Risk Management: Making Your Trades Profitable
Risk can be defined as a situation involving exposure to danger, and everyone knows that trading Forex is risky (especially the people who trade on a regular basis).
Traders are constantly trying to develop better strategies that will help them predict where the market will go with more accuracy. Risk, a lot of people think, is when the future doesn’t do what we tell it to. We expect the market to go up, but risk the market going down.
However, risk is actually much more complicated than that, and a lot more important to investment. In fact, risk is the very reason that stock markets and trading exist in the first place. Trade and investment certainly existed before Mercantilism, but it was during the 15th century when equities trading, as we know it today, began to develop.
The major factor in developing trading houses–originally investors who would get together in coffee shops in Venice, Genoa, London and Amsterdam—was helping investors cope with risk. Back then, major trading involved spices from the Orient and futures on crops.
Mills established the first form of “futures” by trying to guarantee grain supplies when farm output depended on varying weather conditions. Millers would agree to buy grain from farmers at a predetermined price early in the season, so that if there were early rains and grain crops spoiled (causing a spike in the price of grain due to scarcity), they could still afford to buy it. Farmers would sell their “future” grain to guarantee that they would still get a profit if the weather was especially good and prices fell due to extra production. Therefore, futures were created to help businesses cope with risk.
The stocks and shares we trade today come from shipping. Although bringing spices, silk and other commodities from the Orient was very profitable, ships had a nasty habit of being taken by pirates or sunk in storms. Sometimes shipments were delayed. If an investor put all of his money into one shipment, he could make a lot of money; but if something happened to the shipment, he’d be completely ruined (the apocryphal “pound of flesh” being exacted in payment).
To combat this, traders would form “companies” that would spread out the risk of losing cargo, so that if one ship sank, it wouldn’t ruin the business. Investors would have “shares” in the venture; and eventually began to buy and sell the shares.
Hundreds of years later, we have advanced financial systems and institutions; but the basics remain the same: Wall Street, the City… they are all based on instruments designed to reduce or manage risk. Failure to manage risk leads to bankruptcies, stock crashes and even world recessions.
Therefore, it’s important for every trader to understand that risk is an inextricable and essential part of trading within the markets. Risk can never be eliminated: therefore it must be managed.
In popular media, traders are often dismissed as “gamblers” who play with other people’s money. That is not entirely true. It’s an accepted truism that says, “the house always wins.” What’s the difference between the house and the gambler? The house practices risk management, and the gambler does not.
Do you want to be the house or the gambler?
Risk is Profit
Why do people put money in the bank? Because it will be safe there, obviously. Also, they might be looking to get some interest back from it. (Given the economic conditions of today, probably not much interest – but it could be a factor!)
And why does someone start a business? To make money, of course! As well as help out in the community, create jobs, etc. Starting a business, of course, is very risky; and the idea of the entrepreneur is to make more money than he’s putting in.
Now, lots of entrepreneurs don’t have enough money to start their own business, and often have to borrow money from the bank. But that’s okay; the business will make enough money to pay off the loan, and still leave the owner with a profit.
Of course, the interest rate that the entrepreneur will pay for the loan from the bank will be higher than the interest the bank is paying them for depositing their money there. The bank is calmly pocketing the difference for doing nothing more than having an office with a sign that says “bank” above the door.
So why should someone with extra cash not just loan the money directly to the entrepreneur? If they have extra cash, and the entrepreneur needs money to start a business, surely they could make a much better profit than the interest they receive by putting their money in the bank?
The obvious issue is that the money is safer in the bank. If it is given to the entrepreneur, there is the risk that the business might not be as profitable as expected. It might even go bankrupt, and in that situation, what guarantee does the loaner have that the loanee won’t just run off with his money?
Most people are willing to make less money by depositing money in the bank because it’s safer than giving it to someone to start a business. Besides, you can take your money out of the bank whenever you want; but not from a growing business.
There is a direct relation between risk and profit: the more risky something is, the more profitable it has to be to attract investors.
But what does this have to do with Forex? The same principle applies: the more money you want to make, the more risk you have to take. The more risk you have to deal with, the more important it is to manage that risk.
The bank in this example makes money solely by risk management. It collects deposits from lots of people, then loans out the money to lots of entrepreneurs at a higher interest rate. By distributing individual risk through the system, the bank manages the risk involved with giving out loans and provides security to depositors.
As an investor in the markets, you want to move from being the person who deposits money in the bank to avoid risk, to being the bank, where you manage risk by investing in different currencies or equities and obtain a higher rate of return.
The better you are at risk management, the more risk you can take, and the more profit you can make.
The simplest form of risk management is to follow conventional wisdom and not put all your eggs in the same basket. Or, as the suits say, “diversify your portfolio”. Of course, there is a little more technique to it than that (and nowadays we just keep all our eggs in the refrigerator anyway).
Diversity in your portfolio is not about buying different currencies or equities, but evaluating the relative risk of your options and distributing your investments in such a way that you have an acceptable risk-to-profit ratio.
Generally speaking, however, by making several smaller investments, you have less risk than if you make one big investment. This is the principle behind banking. Banks run the risk of their clients not paying them back each time they loan out money. By loaning to lots of people, the risk is spread out over all their clients, and it’s easier to compensate for.
For example, say you have an investment opportunity; it really doesn’t matter what it is. For every dollar you put in, you could get back $10; and you can invest in it as many times as you want. But, of course, there’s always risk, and there’s a fifty-fifty chance it won’t work out (which isn’t all that far-fetched; 50% of start-ups go bankrupt in the first year).
So, if you put all your money into it, you could become instantly rich. But, if things go sour, you could lose every penny you’ve got. So, is it worth it? That was a trick question; that’s something a gambler would consider. Traders should be applying risk management instead.
The key here is that you can invest as many times as you want (just like with equities markets). If you make one investment, you have 1 chance in 2 of losing (a 50% risk); but if you win, you get 10 times back. This is expressed as profit:risk. In this case you have profit 10 : risk 2, or 5:1 risk-to-profit ratio.
If you split your money in half, and buy twice, statistically speaking, one investment will lose everything and the other will pay off. So if you invest $100 ($50 in each), in one you will lose $50, but in the other you will make $500. Net profit? $400. If you had invested all of your money, you could have made $900; but you also could have lost everything.
The important thing to remember here is that by splitting up the investment, you are no longer in an all-or-nothing position (gambling) but in a position where it’s much more likely that you will make at least some profit (investing).
Of course, you can reduce some of the risk by using different techniques to try and figure out what will happen, but you can never be certain of the future. Once you’ve minimized as much risk as you can by researching the investment, you can then reduce the investment’s risk by handling how you expose yourself to it.
There are a lot of nuances to improving your profitability by diversifying your portfolio, and these will be covered in more detail in later lessons.
The Gambler’s Fallacy
Financial experts and traders would like to dispel the myth that trading forex is similar to gambling. It’s therefore annoying for traders to come across something that applies to both gambling and trading. But if it will help them get a leg up on trading, it might be useful to look into.
The gambler’s fallacy applies to a common misconception connected with statistics and probability. Traders use a lot of math, but probability is very useful when evaluating your portfolio risk. Basically, you are trying to figure out the probability of something happening (in trading, the market going up) or not happening.
In this respect, gamblers have it easy: the possibilities of what can happen are relatively limited. In poker, for example, there are a limited number of cards, which makes probability calculations easier. But when trading with currencies, or even stocks for that matter, there are virtually infinite possibilities for what might disrupt the markets. This is why putting backstops in place to protect your portfolio against risk is even more important.
The science of coin flipping
When trading forex, you can boil down risk to two possibilities: up or down. Granted, there are a lot of factors that will influence the market, whether it goes up, down; how far up; whether it’s a panic, a sell-off or short covering, etc. These factors can change the likelihood of whether the market will go up or down, and you should invest accordingly.
But to make things simple to explain the general concept, let’s say there is a 50-50 chance of the market going in either direction. Like, say, flipping a coin, for example. If you flipped the coin 10 times, you might think you could expect the coin to land five times heads, and five times tails, right? 50-50 odds?
That’s the gambler’s fallacy: in assuming that there is any connection between the chances of the coin tosses. If you tossed a coin three times, and all three times it landed heads up –you might think the next toss would be more likely to land heads down. But the reality is that each toss has the same chance of landing heads up or down, regardless of how many times the coin has landed on each side previously.
How does this affect my trading?
Often, this fallacy takes on a different expression in trading. Something like: “well, the market has been going down for four days now, so it’s bound to go up today,” or “I’ve had three losing trades on the EURUSD so far, so the next one is the winner.”
The chance of the market going in one direction or the other depends on the economic factors of the moment, and is not necessarily related to what has happened previously. That might get technical analysts a bit peeved, but the important concept to understand here is that past performance has no effect on the chances of the market doing something.
Consequently, when you are analyzing your risk management strategy, don’t let what the market is doing affect how you make risk decisions. No matter how sure you are of where the market is going to go, there is always a chance that it will go in the opposite direction.
Calculating Exposure through Probability
When you make an investment decision, you are going to do a lot of research to figure out what is the most likely scenario, and figure out the probability of success. How much time are you going to spend thinking about failure? Hopefully, not very much, because if you dwell on the chances of failing, you won’t be optimistic about the investment.
Good risk management is divorced from how likely it is that an investment will pay off. It’s the annoying pessimist in the room, always thinking of the worst-case scenario. But it is possible to turn that into a profit.
Using coin flipping as an example again can make this simpler. Coins are great for these kinds of examples, because they are money and have equal chances of landing heads or tails. Well, actually, it’s closer to 51% heads, because that side of the coin has more mass – yes, someone actually studied this. But sticking with a 50-50 chance makes the math easier.
For this example, assume that you are betting on heads. If you win, you double your money; but if you lose, you lose all of the money you bet. If you bet on one flip of the coin, then you have a 50% chance of winning, and a 50% chance of losing.
But, if you flip the coin twice, how many chances do you have the coin will land heads? Remember the gambler’s fallacy. The chances are still 50-50 for each toss, but not overall.
If it lands on tails in the first toss, you still have another toss and there is still a 50-50 chance that it will land heads or tails. That means that the chance of the coin landing tails both times is 50% of 50%, or 25%. In other words, your chance of losing all your money is only 25%.
Your chance of winning is also 25%, but your chance of breaking even is 50%. The amount of money hasn’t changed and nor have the chances, but by splitting your money into smaller amounts and making several bets, you are statistically reducing your chances of losing money.
What about Forex?
This has an even larger effect on currencies. Usually, when traders make an investment in a currency pair, they can put a stop loss level. This means that the broker will automatically sell the investment if it drops to that level. Traders can set a stop at a fraction of the expected gains. For example, if you expect the asset to gain 10 pips, you can set an order at 10 pips. This means that you are risking 10 if it goes up by 20 pips.
(Bear in mind that while the markets do sometimes spike dramatically, these numbers are excessive and are purely to help you understand the workings.)
If you put all your money into one investment, you could either make 10 or lose 10. If, however, you split your money into two investments, one after the other, your chances are:
|First investment||Second investment||Profit||Chances|
|EURUSD goes up 20 pips||Market goes up 20 pips||40||25%|
|Market goes down -10||10||25%|
|EURUSD goes down -10 pips||Market goes up +20||10||25%|
|Market goes down -10||-20||25%|
Notice that by splitting your investments, you now have a 75% chance of making some profit and only a 25% chance of losing. Significantly, this is without changing any of the variables that made you choose the investment in the first place: simply by managing your risk through probability, you can make your portfolio more profitable in the long run
Of course, there are a lot of other factors that influence these outcomes in the real world, but the basic concept is to spread risk through smaller investments. There are ways to calculate the ideal exposure, which will be covered later.
An often-ignored factor in investment that’s particularly relevant to overall portfolio management, and also touches on how to deal with risk, is variance.
The term is borrowed from game theory, which studies how to optimize different winning and losing scenarios. Variance is also a very common concept among professional gamblers – and although there is a clear and definite difference between gambling and investing, some of the risk mitigation tools from gambling can be useful while trading with currencies
Basically, variance deals with how money is made and lost during investing. Understanding variance requires accepting an important concept of trading: no one, ever, finishes in the money all the time. Eventually, everyone is going to have losing trades; this is completely normal. Sometimes they will be individual trades, sometimes they will be part of a series. But, ultimately, a successful trader realizes this and takes steps to avoid it
Understanding how those gains and losses cause a portfolio to “vary” in size is the basics of variance study. A study by a major retail trading company found that, on average, traders were right around 64% of the time. The normal distribution was between 60 and 70% of winning trades
This means that the normal, average trader is going to lose money on 30 to 40% of their trades, depending on the situation. It’s important to understand how likely it will be that you will have losing trades
But the really important part of the study was the difference between profitable traders and non-profitable traders: they both had, statistically speaking, the same winning ratio. The difference was that profitable traders made more money on their winning trades than they lost on their losing ones; while unsuccessful traders lost more money on their losing trades than they made on their profitable ones
This is a very important fact in understanding trading psychology and success: the difference between a successful trader and a non-successful one is not necessarily better prediction of where the market is going, but to have better risk management to ensure that losing trades don’t take too much out of the portfolio
Once you understand that you will have losing trades, the question is: how will that impact your portfolio? Losses have a bigger impact on your profitability than equivalent gains. Therefore, it’s important to build a certain amount of “cushion” into any trading strategy in order to absorb normal trading variance
This is why traders are constantly studying past performance to understand how likely and frequent their losses are. This allows them to more accurately measure their capital margin to account for variance
The “cushion” allows a trader to absorb losses without changing their trading method. It’s also important to understand that losses can come in “runs”, where there is a series of trades ending in the red, one after the other. This can be quite stressful, and besides being able to manage the money aspect, you need to be aware of the psychological part as well
Variance is determined by calculating how much is made and lost over time. For example, you could have two trades post gains, and one loss (this would be a 66% gain ratio). This concept should not be confused with statistical variance; statistical variance assumes data at a single time point, but in trading, variance occurs over time. In this case, your variance would be 50% of your profitability. In other words, for $1 that you make, you are likely to lose 50 cents. So, if you are expecting to make $1,000 over the course of your investment cycle, you will need to consider having a $500 “cushion” to account for variance
Unfortunately, there is no way to predict a person’s variance. Not only does it vary from person to person, but from strategy to strategy, and from risk profile to risk profile. All traders can do is keep a meticulous record of your trades, and figure out for themselves how much their strategy can afford to “lose” in pursuit of profit objectives
Determining the Right Risk Ratio
The concept of reducing portfolio risk by making investments of a smaller size has already been explored. By spreading risk over several investments, traders can leverage probabilities so that more of them will pay off, and in the long run, they will make a better profit. But what size investments should you be making?
Luckily, there is an ideal risk to portfolio size that traders can use to maximize profits.
Ultimately, each individual’s risk ratio will depend on their particular investment goals and style, but there are some rules of thumb that can applied for a good starting place. Basically, you need to balance two risk factors: individual investment risk against portfolio risk
The previous section showed how investments with more risk were offset by higher profit. That’s why –as a general rule– it’s best to take on as much risk as possible within a safety range, in order to maximize profit. On the other hand, portfolios can be managed in a way that allows traders to reduce overall exposure, making a risky investment less “risky”, because the risk management strategy helps mitigate the effects of an adverse outcome in the markets.
By reducing the level of risk, you are essentially creating more portfolio value. This allows traders to either take on more profitable investments (higher risk) and make more money, or to have more security with the portfolio and invest more in it. The liquidity problem
Another important factor is that adverse market performance has a larger impact on a portfolio than a positive outcome. For example, let’s say the market can go up 10% or go down the exact same amount
If you start out with $100, and the market goes up; you’ve made $10, and your portfolio is worth $110. But on the other hand, if the market goes south, you lose $10, and your portfolio is only worth $90. That’s too bad, but maybe you can make 10% profit next time, right?
Let’s say that you do. 10% of $90 is $9, which means that after losing one and winning one, you now have $99. That’s $1 less than you started out with.
This is how losing has a bigger impact on a portfolio than winning. Your portfolio has lost value, there is less money to invest, which means it is not possible to recover as much as you lost with an equivalent return percentage.
If a trader can either win or lose 10% and has 50-50 odds on winning, he will lose $1 on average with each two investments, and eventually, his portfolio will reach zero.
This is why taking a 50:50 risk on an investment that will only double (100%) your money is not a good idea. You need to have more than a 1:1 risk to reward ratio, either by having more than 50-50 odds or by investing in something that pays out more than 100%.
Determining investment size
Considering these two factors, it is possible to work out a likely ratio of how much of a portfolio should be risked at each investment. Keep in mind that this will vary depending on the trading strategy, and that it applies to investments that have more than a 1:1 risk/reward ratio.
The smaller the percentage of the portfolio, the less risk; but on the other hand, the less profit made. You could use complex computer models to find the exact ratio, but fortunately someone has already saved you the work. FXCM, a leading retail trading company, did a survey of all their investors’ trading habits, and after analyzing millions of traders and billions of trades, they found that the most profitable risk percentage is just under 3%
If you risk less than 3% of your portfolio per investment, then you don’t have as much profitability. But if you invest more than 3%, the liquidity problem where losses have a bigger impact than gains asserts itself.
This doesn’t mean that you should invest only 3% of your portfolio, and leave the rest untouched in your account. It means that for each risk scenario, you should only risk 3% of your portfolio to ensure maximum profitability. This could mean that you risk 3% in one stock you are expecting to hear news about, while another 3% could be invested in long-term bonds, and a further 3% could be in gold, etc.
Eventually, you want to have as much of your money as possible “working”, but you need to diversify your portfolio’s risk profiles in such a way that you are not subject to losing more than 3% in any given risk scenario.