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Risk Management: Trading the Setup

Liam McMahon WTCG Currency Strategist

The Importance of Managing Risk

Trading is about 2 things:
Patience Risk Management

A great trader will fail without risk management, whereas an average trader can succeed with good risk management It is impossible to succeed without some system for managing your risk.

Trading the Setup: The Risk / Reward Ratio (RRR)

The risk to reward ratio (RRR) needs to be a traders best friend. This is the ratio between the amount of equity or capital being risked by the trader, and the amount of equity that will be gained with a successful trade. To figure out the RRR, a trader needs to look at his stop and his target. A 10 pip stop and a 20 pip target yields a RRR of 2:1, while a 15 pip stop and a 60 pip target yields of RRR of 4:1. In general, traders should be hunting setups with at least a 2:1 RRR, and should always avoid setups with a negative (more risk than reward) RRR.

Probabilities Matter
While it would be easy to set a 10 pip stop and a 10,000 pip target (a nice 1,000:1 RRR), this type of trading still yields a negative result, because the odds of a pair moving like that is virtually nil, not to mention it would mean having equity tied up for years and years on one trade. Traders must look for setups with well-defined stops, and well defined targets. These stops and targets can be defined using any number of different strategies: moving averages, technical formations, Elliot Waves, Ichimoku, Fibonacci levels, etc. The trading system or strategy almost doesnt matter whatever works for the individual trader. The key is ensuring a healthy RRR by using well defined (and therefore significant) areas for stops and targets.

Risk Management Rules

Never have more than a 50 pip stop Never have a wider stop than is necessary for the setup Never have worse than a 2:1 RRR; 3:1 is preferred Move stops to break-even and take profits after the trade has moved in your direction the distance of your stop. For example, if you have a 20 pip stop, move your stop to breakeven and take profits when you are 20 pips in the money. This means of your trade has a 1:1 ratio, but ensures that you get something out of the trade.

Rules, Contd.
After moving the stop to breakeven and taking profits, let the trade run to targets, preserving your RRR. Aggressive traders may wish to trail their stop in increments of their stop (trail your stop 20 pips every 20 pip move), which maintains a positive RRR. This set of rules will ensure that your RRR is never negative, and helps protect profits, while still allowing the trade setup to work.

Other Assorted Rules

NEVER move your stops (increase your risk). Place your stops at the point where the trade setup will be invalidated. If you do this, there is no reason to move your stops. Rookie traders often move their stops because they hate being wrong. Doing so destroys the RRR, and results in heavy losses. If you add to a position (whether profitable or losing), make sure that you had planned for that possibility when you planned the trade, and that the possibility is included in your RRR.

You will never go broke taking profits.

False. Taking early profits is probably the second most common reason (behind moving stops) new traders fail. Why?
If a trader risks 40 pips on every trade all losing trades will result in -40. In order to have a positive RRR, targets should be at least 80 pips, meaning that hitting 50% of your trades will result in a tidy profit. If the trader panics, and takes profits after 20 pips every time, hitting 50% of your trades will result is a tidy LOSS.

Taking early profits requires traders to be correct far more often than is likely in the challenging world of forex. When taking profits early, make sure it is done in a way that preserves a positive RRR, as discussed above.

Conclusions
When planning your trades, remember to ensure a positive RRR; including any add-ons you have planned When actively managing your trades, ensure that a positive RRR is maintained through profit taking. Never move your stops (increase your risk). Trade setups have a stop and a target that are defined by price action; regardless of the strategy you use. Stick to your setup.