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Controlling Expectancy And Capping Risk
As professional traders, it is not our job to always understand the market moves; our job is to manage risk, and control expectancy. One of the biggest issues a trader has to learn even from the first days of trading, but usually only after multiple blown accounts, is how to plan, execute, and walk away.
Many traders just focus on the reward, and do not concentrate enough on the risk that goes hand-in-hand. An issue many traders seem to pass by is that risk and reward are directly proportional; as one increases, so does the other.
A forex trader should avoid taking trades with an associated risk of more than 2% of their trade account; 30 years of traded market experience confirms an opportunity that sets which is worth risking more is rare indeed. Ideally, forex traders should focus and get into the habit of planning lower-risk trade set-ups, ranging from 0.5%-1.0% of the available account balance.
The lower-risk trades may not produce the same big-bang financial reward, but they will keep a trader in the game for longer, and will create a solid knowledge base that a career can be built upon.
With some retail brokers now offering micro and mini lots (1K and 10K trade lot size), that cost a few dollars in exposure, and sometimes pennies to put on, a new trader does not need an account stacked with thousands of dollars just to learn to trade and manage risk.
A trade has two possible outcomes – either you win or lose. As such, in a control environment, a trader has a 50% chance to lose the next trade. Chances for two consecutive trades with the same outcome (win or lose) are 25%, while chances for three consecutive traders with the same outcome reach 12.5%. Even though the percentage is relatively small, new traders continually chase the game, defying logic, and defying solid money management in the 'fear of loss' gamble that comes with increased expectancy, reducing discipline, and irrational planning.
A good trader will psychologically prepare for such events as having losing trades; it is a part of the work at hand, and is an inevitable part of what traders do. Controlling expectancy is as important as controlling risk, and traders soon learn that the two go hand-in-hand. Too much risk can kill an account, however good the potential set-up may be, and should be a major focus for new traders, who tend not to control their emotions in the heat of the game being played.
Anybody looking for low-risk trades, in the credit-crisis fall-out environment that controls the global market at present, should look at a CD or savings account; this is not our Grandpa’s market. With that being said, the other extreme is taking risk that is not at all justified, in a market that now moves in an average day, what it took a week to achieve not too long ago. Risk, expectancy, and daily trading range, all have a part to play in planning a trade, and should be in addition to strong technical and fundamental outlooks, rather than a by-product or after-thought.
Any trader looking to achieve more than 50% of the average trading range in quick time, in an automated market that switches gears as easily as Lance Armstrong riding the mountains in the Tour de France, needs a reality check; however strong the potential trade set-up is, it needs a plan to bank green, and control risk.
The current trading environment requires that hitting 50% of the daily range movement, then has 50% sold, and the Stops pulled up. That controls both expectancy and risk, in one easy play. The 'fear of loss of potential gain' needs to be eliminated; sell 50% when 50% of the daily range is hit, and pull the Stops, then do not look back in anger at what subsequently plays out. Plan it out, and move on, banking green as you go, off a plan set out ahead of time.
When planning any potential position, traders should start with the Stop Loss area, and then look to where a potential profit could be hit, ensuring to plot somewhere that is realistic and within 50% of the daily trading range. Those who look at the target area first, and then find a Stop Loss area that accommodates that dream of reward, will tend to overplay the expectancy in a potential trade.
In forex trade, using mini-lot positions, each pip costs $1 of a mini lot exposure when trading Usd based pairs. On a $5000 account balance, a 2% risk equals $100 of exposure; and with a 40 pip Stop the risk is 2.5 mini lots per trade. With 2% being the absolute maximum exposure at any one time, that means that no new trades can go on until the original position has hit profit and the Stop has been moved to break-even.
Overleveraged trading is thrilling to some, while the idea of a casino type Lotto win is all consuming to others. Trading any market, however, is a business, so leave the gambling to the Thursday night card school, get a Plan, and get serious about managing risk and expectancy, because without it the game soon ends, especially when leveraged at 100:1.