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Equity & Risk Management

Introduction

The interesting thing about Forex trading is that many refer to it as a “highly volatile” market. The truth is that it’s not, Brokerage firms have created this illusion of volatility for traders with leverage. This can be a blessing for the traders that take advantage of the opportunity properly. It can be a curse for those that don’t understand how leverage affects trading the market.

What is a PIP? – Price Interest Point

Price Interest Points, commonly referred to as PIPs, are the universal measuring stick of movement in Forex trading. They are represented by change in the 4th and 5th decimal place of a currency ratio. This is what it looks like in Metatrader 4 (MT4):.

Forex Spread and PIP Values

There will always be two prices listed, the Bid Price and the Ask Price. When opening a trade as a seller, you will be shorting the currency pair. You enter as a seller when you are expecting the chart to move downward. Your cost, if paying a spread (most common), will be the difference of these two prices.

Spread = Buy Price – Sell Price

You will notice that not all PIPs are worth the same amount. For example, 1 PIP trading the EURUSD will be worth more than 1 PIP trading the GBPAUD. To avoid getting confused about PIP values versus lot size, use this as a rule of thumb:

1 PIP in 1 Standard Lot: 10 Base Currency Units
1 PIP in 1 Mini Lot: 1 Base Currency Unit
1 PIP in 1 Micro Lot: .1 Base Currency Units

Traders will have the option to trade any multiple of Micro Lots, Mini Lots or Standard Lots. So trading something like 3 Micro Lots on a pair will yield PIP value of about .3 Units of a Base Currency (i.e. 30 cents if USD). Similarly, 5 Standard Lots will yield PIP value of about 50 Units of a Base Currency (i.e. 50 Dollars if USD).

Leverage – Blessing or curse?

Leverage in the Forex effectively magnifies every move that the market makes. Without leverage, Forex trading would be attractive to the super rich alone outside of banks and large institutions. As a matter of fact, it was limited to those parties alone until 1994. The ability to control a large sum of money with a small one, leverage, makes it worthwhile for the average retail trader.

Higher leverage will allow you to open trades with a required level of margin. For example, with 100:1 Leverage a Standard Lot can be opened with roughly 1000 Base Currency Units of Margin from your account. With 1000:1 leverage the same position can be opened with 10 Base Currency Units. This doesn’t mean you should base the size of your trades on the leverage you have available. Base the size of your trades on the risk involved.

The dangerous part with leverage is that most people only look at the positive side of “how much I can make if it goes my way”. This is a vanity you must avoid. The easiest way to win in trading is to survive when you lose. If you can control yourself in how much you risk per trade while following the rules of your strategy, then you have a chance at making leverage the blessing it should be.

How much should I risk? – MOST IMPORTANT QUESTION

There are three types of strategies for you to trade: Position, Swing, or Scalping. If you are trading responsibly, you will have a stop loss no matter which one you choose. Pick an amount of money that you can carelessly afford to lose, literally an amount that you would be comfortable risking on flipping a coin. Thinking about your risk in this manner will help you understand your risk tolerance. Warren Buffett might be comfortable flipping a coin for $1,000,000 at a time. You on the other hand likely have a smaller number in mind.

The key is to choose the proper lot size for the number of PIPs you are putting at risk. No matter what you do, if you are risking more than 5% of your account at any given time you’ll likely wish you hadn’t. The least stressful and most sustainable way to do things is to risk 1% at a time. These percentages include ALL your positions.

HERE’S AN EXAMPLE:

Let’s imagine you open an account with $1000. You want to risk a maximum of 1-5% of your account at a time. The number of PIPs you can risk will be somewhat limited. This is what it might look like with Micro and Mini Lots:
***Base Units equate to the base currency of your account (USD, GBP, EUR, etc.)

Micro Lot

% Account at RiskAmount at Risk (Base Units)PIPs at Risk
110100
220200
330300
440400
550500

Mini Lot

% Account at RiskAmount at Risk (Base Units)PIPs at Risk
110010
220020
330030
440040
550050

You may be wondering where Standard Lots fit in this example. The truth is that they don’t. If you are trading 1000 units of a base currency (i.e. USD, EUR, GBP), then you should not trade Standard Lots no matter how much leverage you have access to.

In reality, trading Mini Lots given a 1000 Base Unit account size would greatly limit your opportunity as well. Your opportunities would be limited to Scalping and make your margin for error extremely low. Unless you are expecting to be perfect right from the start, you are better off trading Micro Lots. Doing this will allow you to figure out if you are best at Scalping, Swing Trading, or Position trading and afford you the opportunity to test your strategy.

If you wish to trade larger lot sizes or more of them, either fund your account with more money or grow the account through compounding. If you can’t afford to lose any more than is already in your account, follow the rules and earn your opportunity. Standard Lots, in our humble opinion, should not be traded with an account of less than 10,000 in base currency. Even still, that activity should be reserved to highly skilled Scalpers with a proven track record of success.

Risk vs. Reward in Forex

At minimum you should win half of your trades. If you’re consistently winning less than that, you should consider flipping your strategy as it wins less than it loses. If your average gain is 1.5 times your average loss, then you only must win 4/10 trades to be profitable. Any more than that ratio and you can make considerable gains.

Some traders boast of incredibly high gains 10 times the size of their average risk. Those opportunities are rare unless you are incredible at finding the “perfect entry point”. Those types of gains are possible, but will require superb skill and a lot of patience.

There is always a “trade off”. Looking for unreasonably high gains versus losses could cause you to miss out on many opportunities. Taking trades with gains less than 1.5 times your average loss will force you to win a very high percentage. Trade small to start off and figure out where you stand in these ratios.

Summary

The amount of risk you take per trade will be directly related to the size of your profits, and your losses. Skilled traders pay close attention to the risks that they are taking and the amount of equity they are risking it for.

Don’t be disillusioned by the wealth of trades to take and try to avoid being too picky. There will be many opportunities to take and you shouldn’t take all of them; however you will have to take risks to make money. Everyone is different, figure out how big those risks are and how often you are comfortable taking them.

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