Risk Management

Profit is the primary motive for all market participants. Just like any other business, where profit is a key
objective, traders would be well served by visualizing their trading activity as a business enterprise.
Revenue growth in conventional businesses is often driven by a business plan and in trading terms this
translates into a trading plan. Analogous to the business world where one would carefully preserve and
deploy available resources, this would be achieved in a trading context through the effective
management of capital.
Costs in trading terms can be thought of as trading losses, and just as any respectable business plan
would include methods for controlling costs, a trading plan would do so by incorporating a methodology
for risk management. Moreover, akin to operating procedures related to cost control in a traditional
business, the primary mechanisms for achieving the same in a trading environment are position sizing,
risk reward ratios and the correct use of stop-losses.
Optimally managing and harnessing human resources is the hallmark of a successful organization, and
in a trading enterprise this would apply to traders themselves. Thus, maintaining the right mindset and
being able to exercise self-control is an integral part of any trading activity and can be thought of as the
key driver of strategy execution and risk management.
The next few chapters deal with these concepts in greater detail. Chapter 2 deals with trading strategy
and incorporating a risk management plan into a trading strategy including position sizing and the risk
reward equation. Chapter 3 deals with the appropriate use of stop-losses which is a key process in risk
management and capital preservation. Chapter 4 deals with a cornerstone of successful trading, often
ignored by novice traders, that of the trader’s mindset and the psychology of trading.

Leveraged trading in foreign currency contracts or other off-exchange products on margin carries a high
level of risk and may not be suitable for everyone. We advise you to carefully consider whether trading is
appropriate for you in light of your personal circumstances. You may lose more than you invest. We
recommend that you seek independent financial advice and ensure you fully understand the risks
involved before trading. Trading through an online platform carries additional risks. General advice only,
not trade advice.
Chapter 1: Trading Strategy For example, a 20% loss on a $1,000 account
would make the total capital remaining $800; which
Traders will most often employ a simple, step-by- then would need to be increased by 25% ($200, of
step approach to their interaction with the markets, $800) to replace the lost capital and total the initial
which ultimately will define their style of trading and $1,000. This highlights the importance of protecting
will have an impact on their trading mindset. This one’s capital and having a risk management
simple, step-by-step approach would often consist strategy when trading.
of one or more tried and tested trading strategies,
A strategy driven approach allows traders to
as well as an effective risk management system to
manage emotions. Market participants, who are
preserve or attempt to grow capital. These, along
motivated by excitement, may often find a roller-
with rules that govern trading behavior, constitute a
coaster ride more rewarding and less expensive.
c o m p r e h e n s i v e t r a d i n g s t r a t e g y. I n h i s
Such behavior often encompasses trading that is
conversations with the world’s best traders, Jack
driven by the emotions of fear and greed which can
Schwager observes,
lead to undesirable outcomes. The best defense
against such behavior is to have a robust and
“A trading plan simply requires sound trading strategy that incorporates financially
combining a personal trading method responsible risk management principles.
with specific money management and The process of trading strategy development in
itself often engenders risk management. This is
trade entry rules.” (Schwager). simply because trading strategies imply the
creation and deployment of low risk, potentially
There are hundreds, if not thousands, of trading high reward approaches to trading. While
methods or strategies that could be applicable to developing the strategy itself, therefore, traders
the global asset classes; from strategies centered screen out high risk approaches.
on seasonality through to purely technical analysis
aimed at exploiting a recurring edge on a price Patience is a virtue rings true in any trading
chart. This ‘edge’ could exist for a fraction of a endeavor and the ability to wait for ideal setups can
second in an arbitrage strategy through to months if have a positive impact on risk. This eliminates low
not years in more long term swing or positional probability trades and allows risk management
strategy. principles to be applied judiciously. The self-
regulatory framework of trading to a plan, reduces
Longevity in the market is often a function of risk the possibility of overtrading, and enhances a
management principles. As an example, if a trader trader’s ability to be patient.
had a $1,000 trading account and risked $250 in a
single trade; a series of four losses would wipe out Trading without a trading strategy is like building a
the account. However, if the trader risked only $10 bridge without a documented plan. Either course of
per trade, it would take a series of one hundred action is likely to lead to unstable outcomes.
losses to total $1,000. A rule of thumb commonly Although the development of a trading strategy is
applied is to limit risk exposure to no more than laborious and time consuming, the resultant trading
1-2% of the trading account on a trade, and to have discipline and risk management that it promotes,
no more than 3-5% of your capital at risk at any through both its development as well as
given time. application, may well be worth a trader’s effort.

Further, erosion of trading capital by a certain “Market participants, who are

percentage requires a larger percentage gain, in
motivated by excitement, may often
order to recoup the loss. A 20% drawdown takes a
25% gain to break even and likewise a 50% find a roller-coaster ride more
drawdown takes a 100% gain to break even. rewarding and less expensive”

A rule of thumb commonly applied is to limit risk exposure

1-2% to no more than 1-2% of the trading account on a trade

3-5% No more than 3-5% of your capital at risk at any given time
Examples are not trade advice – information only
Chapter 2: Correct Use of Stop-losses
The previous chapter highlighted the importance of
a trading strategy and of incorporating risk
management principles in the same. This chapter
encompasses the appropriate use of stop-losses,
which is a key process that a trader may employ to
manage risk.
“Trading currencies and most other
financial asset classes usually involves
the use of leverage which can be a
double edged sword as leverage
amplifies profits but also magnifies
losses”
The judicious use of stop-losses can be an
effective protection mechanism from allowing
losses to run. A big advantage of using stop-losses the right method for you is dependent on your
is that trading accounts do not have to be
constantly monitored when a stop-loss is in place.
Stop-losses are executed as long as market Stop-losses help preserve your capital. Their use is
liquidity exists.
When used correctly, stop-losses can help protect
against a large capital loss. Trailing Stops are a
useful variation on the traditional, static stop-loss.
While static stop-losses trigger at fixed levels,
Trailing Stops are defined by a stop distance -
when prices move in a favorable direction the
Trailing Stop moves accordingly, but remains
stationary when prices move in an unfavorable
way.
Where then should stop-losses be set? This will
depend on the trading strategy you have created. A
general rule of thumb could be to set it at the point
where the trade premise would be invalidated. In
other words, the point at which the trader’s reading
of market direction would be proved incorrect. For
example, a long position in an uptrend may have a
stop placed below the most recent swing-low; since
movement below this level would invalidate the
premise of a sequence of higher-highs and higher-
lows.
There are a number of methods to select
appropriate exit levels, among the more common
ones are based on a fixed percentage at risk,
volatility analysis and/or technical levels. Finding
individual trading style, plan and risk appetite.
important because without capital you can not
trade.
 Using a fixed percentage
of risk for your Stop-loss
O u r f x Tr a d e p l a t f o r m i s
designed with a number of
important risk management
tools to assist you in placing
stop-losses. Our fxTrade
platform has the ability to
calculate a Stop-loss and you
can automatically have a stop-
loss for each new trade if you
specify it in ‘user preferences’.

Past performance is not indicative of future results.

For example, a trader with $10,000 in their account might

wish to set the initial stop-loss order to be no more than
2% of their capital, or $200. If the trader selected a default
position size as 5% of their leveraged NAV, the platform
would automatically select a position size and a stop-loss
level that would equal or be as closely equal to their
potential desired risk level as possible, based on current
pricing:

Please note you can set default stops based on a set

number of pips, as a percentage of your balance (%
balance), as a percentage of your Net Asset Value
(%NAV) or fixed value of your account currency. The
function of determining a stop-loss based on a
percentage of NAV or Balance only works in conjuncture
with setting a default position size.

Benefits to selecting position sizing based on a

percentage of your Balance or NAV:
►  If you suffer losses, your position sizes will decrease
helping you to preserve capital.
►  As your capital grows, this will assist you in
gradually increasing your position size while
maintaining the same percentage risk levels
Past performance is not indicative of future results.

To view all the options available to you for setting default trade settings, click on the
Tools menu on fxTrade, select User Preferences and click on the Trading tab.
Setting your exits on price volatility Bollinger Bands or volatility tools such as our Value
at Risk (VaR) calculator or the Volatility analysis
When working out your exit from a trade whether it
chart provided by Autochartist to assist you in
is your stop-loss or take-profit, it is important to
understanding these price movements.
keep in mind the volatility of the market you are
trading. Put simply, volatility is the amount a price For example, if a trader was looking at a 15 minute
can potentially move over a period of time and chart of EUR/USD and wanted to enter a trade,
knowing this can assist you in avoiding your exits they could reference the Volatility Analysis section
from being triggered too early. of our Technical Analysis powered by Autochartist
for an expected volatility range:
You can use technical indicators which illustrate
price volatility such as Average True Range (ATR),

Past performance is not indicative of future results.

In the above image, Autochartist has calculated that within 68% probability the potential price range for
EUR/USD, for a 15 minute time frame, falls between the prices of 1.1317 to 1.1326 for the expected
period of time. Thus, if the trader placed their exits within this range there is a higher probability they
may be triggered.

Please note there is always the possibility of the market moving beyond the estimated amount shown. In
various markets, major economic events can cause a steep rise or fall of prices in a short period of time.
Therefore, it is highly recommended to take additional measures into account when assessing the risk
associated with trading.
Yo u c a n a c c e s s y o u r
Autochartist portal by clicking
the Technical Analysis icon
l o c a t e d o n t h e f x Tr a d e
platform or you will also find it
under the Resources menu:

Find out more about using the

volatility analysis in your
trading by watching the
following short video.

Past performance is not indicative of future results.

Using Technical levels for your exits one consideration is to place the stop-loss just
below the latest swing low rate. Because the swing
Another method for setting stop-loss levels (as well
low rate sometimes becomes a level of support, a
as take-profits) is at key technical levels such as
falling price may recover before it actually falls
support/resistance, pivot-points or Fibonacci levels.
through a previous support level.
One strategy used by some traders is to use
Setting the stop-loss below the support level
Fibonacci Retracement levels as guidelines for
minimizes the potential loss as the stop-loss is only
placing stop-loss orders. For example, when prices
triggered if the exchange rate falls below an
are trending upwards and you hold a long position,
established support level.

Support and
Resistance Level
Past performance is not indicative of future results
In the example above, the stop-loss could be
positioned below the support and resistance level
which will be at the swing low of the uptrend should
the trade move in the intended direction.
Protection would be offered by the 50% and 61.8%
Fibonacci levels as well as the big number of
1.0900.
When trading in a downtrend and you are short the
currency pair, the usual approach is to set a stop-
loss just above the swing high as this could
represent a potential resistance level.
Once again, the thing to remember is that the rate
may retrace back to the swing high but is less likely
to exceed it. Therefore, setting the stop-loss above
the resistance level means the stop-loss will only
be triggered if the resistance level is broken.
Stop-losses in practice
Once set, stop-losses should generally not be
moved away from the trade direction, as this action
does not constitute good risk management
practice. However, if a position moves in a trader’s
favor, and subsequent price action indicates a new
logical level consistent with the trade premise, then
a trader may consider moving the Stop to a new
level. For example, if a trader was long in an up
trending market, they may consider moving the
stop-loss to the next higher swing low; once it has
clearly formed. Some traders prefer to not
enter stop-losses on their orders and instead
execute them manually.
Fibonacci
Retracement
Trade
Entry
Stop-
loss
This requires constant monitoring in addition to
immense self-discipline and is best undertaken
only by very experienced
“Best-practice traders
generally whofor
calls arethe
able to
closely follow their positions.
use of automated stop-losses via order
tickets at the time a trade is setup”
An unfortunate fact of trading is that gaps occur in
pricing. A gap can be caused my many factors and
can occur in the direction of the current market
direction, as well as against it. If a trade is open
and prices gap against the trade’s direction,
the stop-loss would be triggered at the next
available price point. In such a situation there may
be a difference between the point at which a stop-
loss was set and the price at which it was actually
executed. This difference is commonly referred to
as slippage and is an unavoidable risk of trading.
Trading, in essence, is an activity governed by
probabilities. While one can and should stack the
probabilities in their favor by adopting an
appropriate trading strategy, there are no
guarantees that the market will behave as
predicted. Thus, even the most reliable strategy,
when executed flawlessly, may result in negative
outcomes. Stop-losses are a mechanism that can
provide traders a method of preserving their
capital. One cannot trade without capital.
Chapter 3: Trader's Mindset

Trading can be thought of as a series and leaving money on the table (Douglas, Trading
of independent trade events; with one connection in the Zone), which covers the fear-greed
between these events being the trader him/ continuum experienced by traders.
herself. Thus the psychology of the trader,
Honest introspection would in all likelihood lead
his mindset, is one of the key determinants of the
us to conclude that the reasons we move our
outcome. The two primary emotions underlying a
stop-losses, or in some cases trade without one,
trader’s mental makeup are fear and greed
thereby allowing losers to run, is governed by the
(Elder). A similar sentiment is echoed by Mark
first two fears identified above, losing and being
Douglas,
wrong. Importantly, one’s perception of reality is
“In the market, the fear of losing one’s conditioned by what we believe or want to see.
The ‘buy, hope and pray’ trading strategy could
fortune is every bit as intense as the be related to this behavior.
fear of losing one’s life. The best
For example, price action may clearly indicate an
traders aren’t afraid.” (Douglas, The uptrend, while the trader who has a short position
Disciplined Trader). open perceives (and thus believes) that the
market will soon correct downwards. On seeing a
normal counter trend retracement their hopes rise
Coupled with the instinctive fight or flight instinct and their belief is reinforced.
that we as humans have, fear and greed can Moreover, many traders are affected by the
make us react in ways that often restricts us from endowment effect. This means they develop an
effectively managing market risk. unhealthy attachment to their trades and keep
Given the self-evident nature of the adage them open longer than they should. This will likely
relating to letting profits run and cutting losses lead to a significant loss in their invested capital,
short, why is it so difficult to abide by? Mark not allowing for future trades to occur. Traders
Douglas identifies four kinds of fears that traders need capital to trade, which is why it needs to be
have. They are: losing; being wrong; missing out; protected.

Impulse-trading and revenge-trading are two self- wants and desires for the market. In order to better
sabotaging behaviors noticed in some traders. manage risk, a trader will need to accept and
Impulse trading involves taking trades without internalize this fundamental axiom of trading.
adequate deliberation and analysis. Revenge- Though traders cannot control what the market will
trading involves re-initiating a losing trade driven
do, they can control what they themselves will do
by the frustration of having being proven wrong bynext. Overcoming fears by accepting that losing
the market. Both of these may also involve taking trades are not a reflection of one’s shortcomings as
low percentage and high-risk trades to recoup a person, but rather an immutable by-product of
losses. These behaviors can be explained by the the trading business, can help one to operate
fear-greed theory, as well as Mark Douglas’ within the parameters of their risk management
classification of fears. plan, with focus on capital preservation and
attempt to control the negative impact of risk to
The market is always right and it will do what it
their trading accounts.
wants to do regardless of a trader’s own beliefs,
Summary
The objective of trading can be either capital growth or cash flow generation; both of these, by definition,
require an initial capital investment. By implementing a risk management plan, Traders can preserve and
protect their capital. A risk management plan, as we have seen in the preceding chapters includes the
implementation of a well thought out and documented set of rules with capital preservation as one of its
primary objectives.

Should you have any further questions and need assistance in any way, please contact your local
OANDA representative at http://www.oanda.com/corp/contact/.

Works Cited

Douglas, Mark. The Disciplined Trader. New York Institute of Finance, 1990. Print. Trading in the Zone. New York
Institute of Finance, 2000. Print.

Elder, Alexander. Trading for a Living. John Wiley and Sons, 1992. Print.

Schwager, Jack D. The New Market Wizards. Harper Business, 1992. Print.