Trading can be rewarding when the conditions are favourable but it comes with its fair share of risks. As an active trader, you must anticipate situations that can go wrong which will require you to have a ready and studied plan to counter. So, how can you best calculate the risks that are part of trading?
A trader knows that protecting his capital is just as important as making profits using it. With a focus on risk management, the approach to trading, be it the stock market, futures market, CFDs, Spread-betting and foreign exchange (forex) markets the first step, therefore, is to know how to calculate a risk in a trade.
In forex trading, a trader works with pips, a concept unique and integral to forex trading. Pips are the measurement used to indicate the change in the movement of the price down to decimal places. Usually, most currency pairs quote their price movement and the bid-ask spread in pips. A pip denotes the smallest unit of a currency’s exchange rate and its movement. In numerical terms, this is usually one hundredth of a percent or 0.0001 which is the fourth decimal place.
A good starting point to build a trading style that has a focus on mitigation of risk is deciding on what the risk limit should be. What is the maximum risk percentage of your account balance that you are willing to apportion per trade?
Most traders prefer to stay within the 1% to 3% band of exposure per trade to the account balance they work with. This is the overall risk exposure the account is being subjected to. This means, if you decide to opt for 3% as your risk for your account if there are two concurrent trades being entered into, these would have to be at a 1.5% each?
The following example can give an indication of how to calculate your risk while trading.
If you have an account balance of USD 1000 and enter into a trade on EUR/USD at 1.41764. As per your research, your outlook on this currency pair is bullish and you expect it to climb further. But you are also wary of a possible slide in the price and want to set a stop loss at 1.41714. Here, the inclusion of a lower level helps mitigate a higher risk. Even if there is an eventuality of the market falling, the stop loss that you have set at 1.41714 means a drop of only 50 pips from the original price you bought it. This translates to, at $ 1 per pip, a loss of only $ 50.
If you were trading this against a margin, the exposure here is only to the extent of the drop in pips and will not impact your overall margin.
Now that you have a basic foundation planned for your forex trading, it is time to understand the elements of risk calculation and management.
Stop Loss Orders
One of the concepts that are relevant to the element of risk in trading against the risks of a volatile market is the Stop Loss. This is one of the three decisions that traders have to take while finalising a trade. The other two are the entry price for a trade and the target price at which the exit is planned for after making a profit.
A stop loss order can accompany an open order and serves to lessen a potential big loss that can occur if things do not go as per plan. Despite a trade having been planned well and the upside far weighing the downsides, there can be unforeseen developments in every investment. This is where having a harness at a lower price can peg the losses arising out of prices taking a free fall.
The stop loss price can be set at a level that is appropriate to the support seen earlier. The moment the possibility of a fall in price sets off, the stop loss works to close out the open position.
There are variants to the conventional stop loss that can give a trader more flexibility. An example of this is a trailing stop that is a moving arrangement with preset levels that can be defined depending on the movement in prices. Stop loss can be placed only at levels under the trade opening position but orders are open to amendment.
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Position sizing is another strategic methodology that will help you find the approximate amount of units you should trade to control the maximum risk per position.
The difference between their entry price and the stop loss level gives a clear picture of the risk on the position. Having a fair understanding of the risk per pip and where your stop is positioned can help you determine the risk. Stops are placed in positions based on different variables. One should be aware that inspite of using correct position sizing, traders can lose more than their specified account risk limit if a stock gaps below their stop-loss order.
Pip risk is the difference between the entry point and the point where you place your stop-loss order. To find out how much per pip a position will gain or loss, a trader needs to realize what size constitutes a pip movement.
An accurate calculation of the pip value is considered to be an accurate assessment of the risk you are taking by holding a position.
The pip calculation methods of CFD and Spread-betting are different. The CFDs have a standardised contract for each market while spread betting prices every market on a per point basis.
One needs to have a clear understanding of how much money is at stake in each trade. This will help you manage your risk effectively. Trade risk management is the ability to contain your losses per trade. A smart trader is not just one who knows how to make a good profit but also one who knows how to keep his losses down. This is why it becomes crucial that you know how to calculate your risk while trading.
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