Forex Risk Management & The Famous 1% rule

Trading in the forex market can bring potentially incredible returns, but without proper risk management, these gains are nearly impossible to achieve. Risk assessment is an essential step for any trader looking to maximize their earnings and limit potential losses – it’s not just about how much you gain, but how much of your capital you’re willing to lose as well. Stop-loss orders act as a form of protection from huge losses; they set limits which kick in when certain predetermined conditions are met on the exchange rate or price movements within specific markets. By taking advantage of such tools traders significantly decrease risks while having access to unlimited opportunities associated with this lucrative investment channel.

A ‘trading plan’ is the actual strategy or method employed consistently by a trader to yield 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, Asia), 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 classed as part/section of a ‘trading plan’.

Risk Management is regarded by many as the backbone of trading. It requires a lot of discipline to uphold and strictly adheres 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 in one’s trading can determine whether one 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 aspects of losing 1%. I’m pretty sure it’s common sense when I say that losing 1% of $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 has their 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% per cent per trade is better for longer-term success.

This rule signifies that a trader must at no cost risk more than one per cent 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 unfavourable trading events.

For example, if a trade moves unfavourably then it will get stopped, and the downside effect would be reduced as the losing trade position will reflect 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 the total capital amount invested and the 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 is 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 per cent (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 a day trader, a swing (medium-term) trader or even a long-term trader. The 1% rule is a 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 the 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 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 is 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 rules. It almost feels like 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 to 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 your current trading capital is $600, it sounds foolish to apply a 1% risk rule to $1,000 and lose roughly ~$10 when in fact you are losing $10/$600= 1.67%.

As mentioned before the ‘Stop loss’ or ‘Stop Order’ is the 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.