What is Forex Risk Management and the famous 1% rule?

By Ekzaga Staff

28 August 2018 2:55 pm


 

Risk management is all about developing a strategy for the identification, evaluation and analysis of possible risk that may come up while trading any market. Every forex trade comes with a certain percentage of risk. In simple terms, it’s defined as how much capital one is willing to lose in order to gain. Forex or any other market can be traded without risk management but you can potentially stand losing your capital. Many of the times traders get confused with the meaning of Risk Management because it’s interlinked with the terms ‘trading plan’, ‘Lot size’ and ‘stop loss’. A ‘stop loss’, ‘stop order’ or even a ‘trailing stop loss’ are trading tools that manage risk.  ‘Stop loss’ or ‘Stop order’ limits the maximum amount you’re willing to lose on a particular trade and the impact it makes to your trading account.

 

A ‘trading plan’ is the actual strategy or method employed consistently by a trader to yields gains and profits on their trading capital. A ‘trading plan’ consists of a strategy or strategies e.g. when you trade Forex: the timezones you trade (London, New York, Asian), technical analysis tools you apply for an entry position, do you trade fundamental news? cross currency pair analysis, risk/reward ratio, risk % per trade, (many more factors) etc. Risk Management would only be a classed as part/section of a ‘trading plan’.

 

Risk Management regarded by many as the backbone of trading. It requires a lot of discipline to uphold and strictly adhere to all your risk trading rules outlined in the trading plan. As the famous quote by Jack D. Schwager, “Even a poor trading system could make money with good money management.” The Little Book of Market Wizards: Lessons from the Greatest Traders.

 

RISK AND THE 1% MANAGEMENT RULE  

As mentioned above, in every forex trade, there is always a reasonable amount of risk attached to it. The level and style of risk management employed to one’s trading can actually determine whether they will have long-term success or failure in the market.

 

This is where the 1% risk management rule comes into play. It’s a great place to start for a beginner trader: it’s easy to apply/calculate and it also plays a significant role in dealing better with the emotional & psychological aspect of losing a 1%. I’m pretty sure it’s common sense when I say that losing a 1% of a $50,000 (equates to $500) on a trade sounds a lot better than losing 5% of $50,000(equates to $2,500). Risk Management can always be altered and changed based on one’s risk tolerance (basically how much one can tolerate losing on a particular trade). ‘Losing’ is not a great feeling or a positive emotion and every individual have their own unique ways of dealing with loss. Some go into a state of despair and some can overcome a loss but require a lot of time and mental effort to deal with the emotions. This is why it’s better to show why in the full picture risking a maximum of 1% percent per trade is better for longer term success.

 

This rule signifies that a trader must at no cost risk more than one percent of his/her account value on a single trade. The 1 % rule keeps capital loss to a low degree and helps protect a trader’s fund from declining significantly in unfavorable trading events.

 

For example, if a trade moves in an unfavorable way then it will get stopped out, the downside effect would be reduced as the losing trade position will reflect on only 1% of the total amount of capital invested. If 10 straight losses were encountered, the trader will only stand to lose 9.56 % of their funds. Hence, the 1% rule preserves a forex trader’s capital in every ramification. You have to remember there are other factors such as total capital amount invested and number of trades you place on a given day or week. If you have a 1 million dollar account it may mean that risking 1%  per trade be too much (equated to risking $10,000). Therefore, you would probably risk 0.5% or 0.25% per trade; but it all comes down to your appetite towards risk.

 

You may have seen in other publications that 3 percent (3%) is known as the golden rule as the forex risk limit. Imagine you open a new trading account with an online forex broker and deposit $1,000. The below image shows a breakdown of five successive losing trades based on the 1% and 3% rule. Please note that it doesn’t take into effect whether a trader is day trader, swing (medium-term) trader or even a long term trader. The 1% rule is universal rule for all types of traders.

 

 

The above is the worst case scenario example of having five straight losing trades and the impact it has on your trading account. Yes, it’s true as the famous proverb says ‘No Risk No reward’ but it’s also true when you change the wording to ‘No money No trading’. I would rather have capital to trade with hence capital preservation should always be the number one stocking point in every trading plan. The above scenario does happen very commonly in the market especially when you’re first starting out in trading.

 

Trading is like a marathon, you have to be in it for the long haul. I have heard many times or heard stories of traders stating they have turned or flipped a £1,000 account by 10 times or 20 times. It certainly can be done and not impossible but realistically you must be used to placing larger trades to make that type of profit. It’s better to start applying a simple 1% risk management rule and make consistent profits month on month. As you can see there is a differential of 9% between the two sets of risk rule. It almost feels you’re playing catchup when you have a couple of losing trades with the 3% risk rule.

 

Important note when applying the 1% rule

When applying the 1% risk rule you must ensure the calculation is always applied on your current total balance and NOT the original deposit of your trading. Let’s say you are down 40% on your original deposit of $1,000 and current trading capital is $600, it sounds foolish to apply a 1% risk rule to $1,000 and lose roughly ~$10 when it actual fact you are losing $10/$600= 1.67%.

 

As mentioned before the ‘Stop loss’ or ‘Stop Order’ is tool you need to set risk management for every trade. Using a Forex Lot Size Calculator is a brilliant tool that helps calculate the maximum amount of money a trader can risk per trade.

 

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