How to know how much of your account to risk and where to place stops
I’ve seen two traders do the exact same trades over time and one lost most of his account and the other became profitable. How in the world can that happen when you’re taking the very same trades? The answer lies in risk management.
They were both wrong on the same trades, yet one was “more wrong” than the other. How is this? He put on too big of a position for the size of account that he held. So this caused him to incur more of a loss and thus it took more to make up that loss.
After all, if you lose 50% of your account, you don’t just have to gain 50% back. No, from that point, you have to gain 100% just to get back to where you were before the loss.
The other trader didn’t dig nearly as deep a hole when it had the very same loss. Why? Because he was trading off of a smaller percentage of his trading account. Therefore it didn’t take as much for him to make up that loss as it did our former trader.
When many traders call up their brokers, they ask “How many lots can I trade?” when they should be asking “How many lots SHOULD I trade”. In other words, look at what is prudent or practical to trade.
Many only focus on the need to “call the right direction” and forget about how much to “lay on the line” on that trade.
Many traders think it is fine to risk 20-30% per trade. However, the losses could be devastating. Others foolishly say they don’t use a stop loss at all. (Translation: They are willing to risk 100% of their account balance on each and every trade.)
Traders should only risk 1-5% of their account at any one time. This is what the professionals do. They aren’t trying to knock it out of the park with a one hit wonder. They are trying to hit a bunch of singles.
So how do you determine if you’re risking 5% or under in your account? This is the amount of dollars that could be lost on the trade between your entry price and your stop price. So you’d see what that would add up to per lot and then you’d know how many lots you “should” trade.
For instance, if I had a $5,000 account and I was willing to risk 5% of my account balance, that means that I could risk 250 dollars on the trade. If you’re in a mini account (which most all of you should be), then you’d be risking about a dollar a pip of movement per lot traded.
So if I could risk $250, then I could trade 1 lot with a stop 250 pips from my entry. I could also trade 2 lots with a stop 125 pips away. If you’re trying to decide on whether to trade a smaller number of lots and a wider stop OR more lots and a narrower stoppick the former. It’s better to let your trade have the most breathing room possible. Ultimately, you want it outside of the typical volatility for that pair. Note about how many pips a pair generally trades from high to low on any given day. This will tell you if you have a reasonable stop distance or not.
Well now you’ve been given a crash course in risk management. Believe it or not, this is far more important than calling the right direction in the trade. Don’t get me wrong, you’ve got to get some trades right, but with the proper risk management it’s not nearly as many as you think.
For instance, some will ask how many trades you’ve won vs. lost. However, what if I won 10 trades of 10 pips each but then had 1 loss of 100 pips. I’m back where I started even though I won 10 of 11 trades.