18. What is risk management?
Risk management is a mathematical system for reducing the risk in your forex trading. In the CashTrap blog post I gave a system for giving points to a particular trade.
In the image here from Hourglass:
- The Alert Panel says Call,
- Beneath the green Bollinger bands it give an “S” which means “sell”,
- The arrow is green and says Call,
- The stochastic line has gone through the green dotted lines and it on its way up.
- The Call arrow is within the green Bollinger bands.
Each of those bullet points represents one point. The more points you have, the lower the risk.
The risk will determine what percentage of your account that you will risk. Here are the numbers:
- 5 points risk 1% of your account,
- 6 points risk 2% of your account &
- 7 or more points you risk 3%.
Keep in mind that there is no such thing is a risk-free trade. What if you traded 10% of your account and you had 3 bad trades in a row. That would wipe out over a quarter of your account. It could take a long time before you restored your account to what it was before those 3 bad trades.
So, never risk more than 3% of your account in a single trade.
Risk management and compound interest
If you understand the wonders of compound interest, it can drastically reduce your risk. This image of a spreadsheet illustrates the results of a trader who increases his account by exactly 3% each day.
If he started with $1000 in his account and increased it by 3%, he would increase his account by $30 the first day. However, if he made 3% the next day, he would not increase his account by $30; he would increase his account by $30.90.
If on day 13 he increased his account by 3%, he would be increasing it by $42.77.
At this rate he would soon have $2000 in his account. At that point he could take $1000 out of his account and reduce his risk to zero. He could start trading as a risk-free hobby.
What is the 8th wonder of the world?
Watch the video below to answer that question.
Risk management summary
Let’s summarize risk management in one paragraph:
- Never risk more than 3% of your account in any one trade.
- Risk either 1, 2 or 3% with the lower amounts going to the higher risk.
- Do not think dollar amount for the amount of your trade. Think percentage of your account. That way you can let compound interest increase your account dramatically.