How risky is a trade - Basic Setups Part 3
In earlier stories in this series on "The Basic Setup", I presented an example gold trade along with the open, stop loss and target prices for a potential bullish setup. In this third part of the series, we discuss the risk we face should the gold price trigger our stop and cause us to exit the position for a loss. We will use this risk calculation to determine the number of contracts we will open in Gold.
This is what we have so far for our important setup variables:
With this information we are almost ready to calculate the number of contracts to open. The math is fairly easy although it may seem unfamiliar at first. If you trade only a few markets (or
instruments) you will soon be doing the calculations in your head. You can even write out a little table of risk amounts and contract sizes and keep it close at hand when examining a new setup.
Step one is to determine how much money you have available to trade risky currencies and futures. Most of the extra risk compared to trading equities comes from the leverage that is available to you via your
margin account with your broker. I will show you how to limit that risk, but these markets will always be subject to unexpected and sometimes extraordinary price movements. You need to protect yourself.
Segregate the funds you have available for trading. You cannot reasonably expect to cover your living expenses until you are a successful trader and that may be months or years away. Keep your day job, keep your real estate separate and preferably maintain a bond and equity portfolio with another broker. On top of that you should allocate enough spare cash for emergencies over the next year at least. Whatever is left over, you might choose to allocate to your futures and
If you are in any doubt, consult a licensed professional. They deal with issues like this all the time. Nobody online can know all the factors you face in assessing your risk profile: your age, your health, your sources of income, your need for emergency funds, etc.
So now you have an amount you can allocate to trading. It needs to be at least $10,000 to get started and preferably much more because you will only be risking a tiny amount of those funds on each trade. Since the probability of losing any one trade is greater than 50%, you cannot risk most of your funds on one trade or you will be wiped out very early in the game.
If all you can spare is $10K after following all these safety rules, you may find the forex market flexible enough for your needs. Even one mini S&P contract in the futures market requires US$4,500 margin just to get started. The forex market is less regulated and allows a smaller margin and a wider range of contract sizes. Carefully assess the risk first before committing funds because a higher margin protects both the brokerage and you.
If USD is not your currency, just substitute your own adjusted numbers below. The calculations are independent of the actual account currency you use until you get to market quotes and your available risk funds. Similarly if you are trading in USD, you will need to make adjustments when trading foreign markets where markets contracts are quoted in Japanese Yen or Euros. For example in forex trading, profits and losses may accrue in units of the
quote currency. I will go into this in greater depth in a later story on forex trading.
Step two is to determine how much to risk per trade or your
position size. We calculated above the amount you can allocate to trading. There are many ways of approaching position sizing but the following lists common amounts to risk per trade given the trader's situation:
- Zero - for an absolute beginner - please start a demo account and test everything first!
- 1% - after you have mastered the demo, and hopefully grappled with your own personality quirks
- 2% - after you have successfully survived several market shocks and have acted rationally and not emotionally to developments in the market
- 5% - only for experts with many years successful trading experience and a trading system that has proven itself through good markets and bad.
In general, proficient traders will risk no more than 2% of their
available risk capital on each trade. That allows 50 losing trades in a row before you are wiped out (as long as you stick to 2% of the original sum and not 2% of what is left over - we can discuss that later).
But is it possible to lose 50 times in a row?
While unlikely, it's not impossible and could happen purely by chance alone, just like throwing 50 heads in a row. Mostly such a low probability outcome would only occur if you trade against the trend, or panic, or trade low probability situations. A more likely outcome is to win more often than you lose but to not win enough to cover losses. Only a systems approach with proper money management could work to prevent that happening but that's the subject of the next series.
If you find yourself losing more than 10 times in a row, stop what you are doing and investigate why. What trading rules are you breaking or what is really happening in the market? Perhaps the trend has reversed and you are stuck in the earlier way of thinking? Time for a sobre reassessment.
The difficulty is that you do not know the probability of a trade's success. You may see from a chart that some trades appear more probable than others, but you cannot see how probable. You cannot say for example, a certain trade is 50% likely to succeed. We can test historical patterns but the future is free to follow its own path.
Black swans happen regularly enough that we should approach every trade with caution and humility.
There is no rule of nature that requires future prices to follow the same path as in the past. You must set up rules for your preferred strategy and stick to those rules. Following a system while those around you are losing their heads will help you score more wins than losses.
We can make our calculations easier here by assuming a trading portfolio of $100,000 and using a trade risk of 2%. That allows us up to $2000 to risk on one trade. Just divide by 10 if you have allocated $10,000 or multiply by 10 for each $1 million.
If we knew the risk on each contract, we could calculate how many contracts to open by dividing our total risk on the whole trade, $2000 in this example, by that risk per contract. It's like having $10 when apples cost $2 each and asking how many apples can we buy. That will be the subject of Part 4 coming up next.
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