Controlling risk is one
of the most important ingredients of successful trading. While it is
emotionally more appealing to focus on the upside of trading, every trader
should know precisely how much he is willing to lose on each trade before
cutting losses, and how much he is willing to lose in his account before
ceasing trading and re-evaluating.
Risk will essentially be
controlled in two ways: 1) by exiting losing trades before losses
exceed your pre-determined maximum tolerance (or "cutting
losses"), and 2) by limiting the "leverage" or position
size you trade for a given account size.
Too often, the beginning
trader will be overly concerned about incurring losing trades. He
therefore lets losses mount, with the "hope" that the market
will turn around and the loss will turn into a gain.
Almost all successful
trading strategies include a disciplined procedure for cutting
losses. When a trader is down on a positions, many emotions often
come into play, making it difficult to cut losses at the right
level. The best practice is to decide where losses will be cut
before a trade is even initiated. This will assure the trader of the
maximum amount he can expect to lose on the trade.
The other key element of
risk control is overall account risk. In other words, a trader
should know before he begins his trading endeavor how much of his account
he is willing to lose before ceasing trading and re-evaluating his
strategy. If you open an account with $2,000, are you willing to
lose all $2,000? $1,000? As with risk control on individual
trades, the most important discipline is to decide on a level and stick
with it. Further information on the mechanics of limiting risk can
be found at the Exiting Trades pages and
Before beginning any
trading program, an assessment should be made of the maximum account loss
that is likely to occur over time, per lot (see "Drawdown"
in "Glossary of Terms"). For example, assume you have determined
that your worse case loss on any trade is 30 pips. That translates
into approximately $300 per $100,000 position size. Further assume
that the $100,000 position size is equal to one lot. Five
consecutive losing trades would result in a loss of $1,500 (5 x $300); a
difficult period but not to be unexpected over the long run. For a
$10,000 account trading one lot, this translates into a 15% loss.
Therefore, even though it may be possible to trade 5 lots or more with a
$10,000 account, this analysis suggests that the resulting "drawdown"
would be too great (75% or more of the account value would be wiped
Any trader should have a
sense of this maximum loss per lot, and then determine the amount he
wishes to trade for a given account size that will yield tolerable