Forex Trading and the Necessity of Risk Management

Consistent and long-term profitable trading in global capital markets can be a difficult prospect, especially for the newer trader. Sure, the idea of buying and holding might sound simple, like anyone can do it: And from an individual trade perspective, it might not appear to take any special skills or background to be able to sit there while a trade moves in the money for you, practically doing all of the hard work itself. But the reality of the matter is that doing this numerous times over an extended period has a tendency to expose weaknesses, whether they be in psychology, execution or a simple lack of experience.
In this article, we’re going to delve into the realm of risk management in trading, specifically focusing on Forex markets. And we’re not just going to give you some tips and pointers while asking you to believe what we’re saying because we really know what we’re talking about. We’re going to accompany these points of emphasis with data based on real trades from actual traders that were looking to pull a profit out of the market, just as we’ve done on prior installments of our DailyFX Traits of Successful Traders research. The data contained in this article has been updated with trades placed with our parent company, IG Group, from January 1st, 2016 to December 31st, 2016; and the entire report is available as a free trading guide from DailyFX at the following link: DailyFX Traits of Successful Traders Research.
Why is Risk Management So Important?
Point blank – you’ll never know the future. That’s it. Your job as a trader is to forecast the future based on the imperfect information available to you in the present. Much of that information will be based on what’s happened in the past, and occasionally we can gleam an idea of potential scenarios based on upcoming economic events or data releases; but, by and large, we’re using the past in the attempt of forecasting the future.
Does the same thing always happen the same way? Of course not: Things change, matters evolve whether we like it or not, and this is what makes the prospect of analyzing markets so incredibly challenging and, to many long-term market participants, fun; because there is never a such thing as ‘perfection’ in a forecast as the world beneath market participants’ feet is constantly in some form of shift.
So, while your analysis is extremely important in getting the highest probability setups that you can find; it’s still just a probability with an opportunity for failure because no analytical method will be ‘right’ all the time. This is where risk management comes in, to mitigate the damage from when your setups or analysis don’t work out so that you have capital left to enjoy the run for when they do.
Winning Percentage is a Dangerous Focal Point
Many newer traders have a tendency to grade their performance on a trade-by-trade basis, looking at each individual setup as if it’s a war that must be won. This is simply not the case, and the reason is that the size of gains and losses are unequal and uneven. A trader could, theoretically, win only 10% of the time and still be profitable; provided that the one winner is worth more than 10x each individual loser. So, while this trader faces rejection 90% of the time, they’d still be profitable. They’ll probably feel pretty negative most of the time, especially at first, as facing rejection 90% of the time is something that most human beings are simply ill-equipped for. Most new traders would be unable to get to this point, as the rejection faced 90% of the time would likely deter them from continuing to trade long enough to learn that winning percentage isn’t the end-all be-all of trading in financial markets.
In our DailyFX Traits of Successful Traders data, we found that many major currency pairs saw traders winning well over half the time, and in some cases even over 60% of the time. So, for about three out of five trades, these traders probably walked away from the position feeling real good about themselves. Unfortunately, the net of their activities entailed a loss, despite the feel-good emotions that might have come from the higher proportion of wins.
Below, we’re looking at the winning percentage in seven of the world’s most common currency pairs. Notice how each is above the half-way point of 50%, with AUD/USD even nearing 66%, or almost two out of every three trades being closed profitably.
Forex Trading and the Necessity of Risk Management
Data compiled by David Rodriguez; prepared by James Stanley
If you’re looking at the above graph, you might be getting excited just at the thought of it, with a greater than 50% chance of setting up a profitable trade. Not so fast, this is just a small portion of the picture. The more important part, and the reason that the majority of the traders represented in the above graph ended up losing is because of just how large losses were relative to the amount made on winners (amounts shown below are in pips).
Forex Trading and the Necessity of Risk Management
Data compiled by David Rodriguez; prepared by James Stanley
The above chart should offset at least some of the excitement from the first graph, as this shows how much larger the average loss was than the average win in each of the pairs listed. Remember that near 66% win ratio in AUD/USD? Ya, that doesn’t matter as much when we see that the average loss is more than twice as large as the average win.
If your numbers line up exactly with the above data, and you’re seeing perfectly average performance; and you place 100 trades in EUR/USD, you’ll win 64 of them for an average gain of 13.1 pips. This means 838.4 pips were made on your winners; but, the other side of the ledger isn’t so pretty, as the 36 losses taken at an average of -26.6 pips given up on each would entail a loss of -957.6 pips. The net would be a loss of -119.2 pips, even with that 64% win ratio.
In Aussie – the numbers are even worse. With an average win ratio of 65.4%, the trader over a 100 trade sequence would win 65.4 at 14.3 pips each, for a total gain of 935.22 pips made. The losses, however, would more than eclipse this amount, as the 34.6 losers at a rate of -31.2 pips each would bring a loss of -1,079.52 pips. The net here, even with the stronger winning percentage, would be an even larger loss over 100 trades of -144.3 pips.
Clear evidence that the stronger winning percentage didn’t do these traders many favors, even if it did ‘feel good’ to win more often.
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