What is risk management?

The vast majority of professional Forex OTC clients and investors agree that the successful completion of transactions with non-deliverable OTC financial instruments is equally based on three factors:

  • Trading System;
  • Capital and financial risk management;
  • Psychology of investing.

Moreover, each of these factors has the same value, which can be represented in the form of a diagram:

The trading system is a sequential set of rules governing a particular strategy, that describes specific entry and exit points and the algorithm of work in the trend and flat market.

Psychology – is the work on negative emotions that arise during transactions with non-deliverable over-the-counter financial instruments and investments. We will talk more about psychology in the following lessons.

Capital management is a part of the trading system that is responsible for position size, level of margin leverage, tactics of setting orders on fixing the price of the underlying assets of Stop Loss and Take Profit. Proper capital management is a vital task for a client who wants to successfully complete transactions with non-volatile over-the-counter financial instruments for a long time.

A detailed examination of all these elements and their implementation in practice will allow clients to maximize profits and minimize losses.

Let’s look at a situation in which all of these elements are largely ignored. To do this, we will give an example of a conditional novice client’s transaction. He has $5,000 on his account and decides to sell the EUR/USD pair with a volume of 4.59 lots at the price of 1.0890. The margin leverage is 100. In this example, the client uses most of their own funds only for this position ( to be exact – $4,998. 51), giving themselves very little leeway for any negative price movement. Each point of price movement will be equal to $ 45.90 of profit or loss. Now let’s see what happens next.

After the release of some economic data, the market reacted with the rapid growth of the EUR/USD pair by more than 100 points. After such a move, the client’s position entered a drawdown of $4,590 within a few minutes, and if the client closes the transaction, only$ 410 will remain on the account, meaning a loss of more than 90% of the margin security.

Such a transaction is a good example of an unsuccessful choice of position size with limited margin security.

Even the best clients of the Forex in Belarus at certain times incur losses, which are an integral part of making transactions with non-deliverable OTC financial instruments. The main task of the investor is to limit losses to a more acceptable level. If you manage your losses and learn how to control them, after a while you will find that the overall result of your operations has improved significantly. One of the main ways to achieve this state is to find the optimal balance between risk and potential profit. For example, many traders do not enter a position if the profit-risk ratio is worse than 2:1. Why these numbers? The fact is that in this case, even if you get three losses in a row, you will only need two pluses to not only return the losses but also to ensure overall earnings.

Now let’s imagine two clients who start with the same amount of $10,000 and use a 2:1 profit-to- risk ratio, but apply different money management strategies regarding the size of the position. The first client uses a very aggressive approach, risking 60% of their capital in each transaction and seeking to make a profit of 120%. The second client is much more conservative and risks only 5% of their funds on the account, earning 10% at a time. For the sake of clarity, let’s imagine that the level of transactions with non-deliverable OTC financial instruments of clients is also the same – each of them makes 10 transactions, where every second one is closed with a loss.

AGGRESSIVE INVESTOR
Transaction Capital Profit (+120%) Loss (-60%)
0 10 000
1 22 000 12000
2 8 800 -13200
3 19 360 10560
4 7744 -11616
5 17 037 9293
6 6815 -10222
7 14 992 8178
8 5997 -8995
9 13 193 7196
10 5277 -7916
CONSERVATIVE INVESTOR
Transaction Capital Profit (+10%) Loss (-5%)
0 10 000
1 11 000 1000
2 10 450 -550
3 11 495 1045
4 10 920 -575
5 12 012 1 092
6 11 412 -600
7 12 553 1 141
8 11 925 -628
9 13 118 1 193
10 12 462 -656

This table clearly shows the trading results of two fictional clients who use different Forex risk management strategies. Despite the fact that both strategies have equal success rates, the same initial capital and the same profit-risk ratio of 2:1, different approaches to capital management have led to Diametric results after 10 transactions.

The aggressive approach of the first client allowed him to get ahead after the first position, but then the results began to fall, and by the end of the «marathon» the loss was about 47% of the initial margin provision. But the second client, despite the low growth rates both at the beginning and at the end of this period, managed to increase the capital by almost 25%. It is not difficult to calculate that if both traders continue in the same spirit, the aggressive client will leave the distance after 10-15 transactions, losing all the money, and his conservative colleague will invariably increase profits.

If you want to learn more about risk management, sign up for a full-time Forex course from FTM Brokers, and ask your Manager to advise you on various strategies for working with capital