April 10, 2013 08:35 AM

**Forex** traders operate in a world of risk. To make money in this game is to take on risk with the hope of reward and it is this balance that must drive every trading decision. Whenever we are in a trade, we are at risk, since any price decline can lead to the loss of capital. Money management is therefore the most important ingredient to successful trading, since without good money management, even the best trader in the world will eventually go broke.

There is no right or wrong answer when it comes to managing risk - each trader must work out what works best on the basis of their trading strategy and their personality. There are, however, a number of things you can do to greatly improve your chances.

Most professional traders trade their account using either fixed lots or fractional bets. Fixed lots trade a set amount for each trade (for example $10 per pip), whereas fractional bets are based on the percentage of the fund that is invested. Neither is better than the other, though fixed lot trading is probably more suited to shorter term **trading**. Fractional trading (trading a certain percentage of the account) will help compounding and generally lead to bigger returns – at the expense of bigger drawdowns.

As a general rule, it is generally advised within the industry to never put more than 1 or 2 per cent of capital on any one trade. Such is the variability and risk involved with **forex**.

When putting money at play in the market, it is important to know exactly what you stand to lose if you are wrong and what you stand to gain if you are right. As a general rule, you should trade small enough so that the risk of going broke is extremely small but large enough to make the experience worthwhile. (If it’s not worthwhile you will simply become bored and will eventually give up).

Of course, because of slippage and unforeseen events, it is impossible to calculate exactly how much capital is at risk but there are a number of things we can do to estimate this.

Stop orders are one of the main tools traders use to manage risk in the market. By placing a stop loss at a certain level, the amount of money that is put at risk is limited to the distance between your entry price and the stop level.

__Example: __

Suppose you have just entered a long position in EURUSD at a level of 1.2950 hoping that it will go up. You do not want to lose more than $500 on the trade so you place a stop loss order 50 pips away from the market at 1.2900 (since each pip is worth $10). Now, even if the market goes to 1.2800, you will be protected and only lose the $500.

*It is worth remembering that sometimes the market may gap down below your stop level, which means it will be filled at the next best price – 1.2895 for example. This can happen in times of volatility and goes to show that risk management is not an exact science. It usually pays therefore to act on the side of caution.*

For some traders, stops are essential tools for ensuring they never lose more money than they bargained for. But for other traders, stops can actually be harmful, since sometimes the market will hit a stop and then reverse back the other way. It is important therefore to test a trading strategy properly and work out where is the best place to put stops for that strategy.

For example, upon testing a strategy it may become clear that the system almost never makes any money after it has dropped 12 pips. A good stop could therefore be placed 12 pips below the market.

Similarly, some systems may lose money if the stops are placed too tight. In this case, you may want to move the stop further away and have the system exit positions using some other logic such as moving average crossovers or volatility thresholds

The important thing is to test the strategy to find out what its characteristics are.

Let’s say we have a trading system that is right 50% of the time with a risk/reward ratio of 2:1. Well, it stands to reason that if these statistics stay the same over a large sequence we can work out the best amount of money to bet, to maximize our return. One method professionals use to calculate this optimal position size is using an equation called the Kelly Formula.

Developed in 1956 by JL Kelly, the Kelly Formula is used by professional traders to find the optimal position size for a **trading strategy**. The formula uses the system’s risk/reward ratio and probability of winning to give the position size that will result in the fastest appreciation of the trading account. The formula is as follows:

**K = W - (1-W)/R**

K = Fraction of Capital for Next Trade

W = Historical Win Ratio (Wins/Total Trials)

R = Winning Payoff Rate

For example, our trade above has a risk/reward of 2:1 with a 50-50 chance of winning. Then -

K = .5 - (1 - .5)/2 = .5 - .25 = .25. Kelly indicates the optimal fixed-fraction bet is 25%.

In practice, many traders then halve the Kelly formula in order to stay on the cautious side.

Another trick traders use to improve their returns is with diversification. Simply put, if we are able to spread our risk across different markets, it is possible to improve the prospective returns whilst also reducing our drawdown levels. For example, let’s say we have calculated the Kelly formula to be 12% of our trading account. What we can do, is split that 12% into 12 positions of 1% risk, or 6 positions of 2% risk. As can be seen, as long as the trading strategy is robust, we will end up with the same reward but with risk spread across different positions.

Successful **money management** is a vast topic and is briefly touched upon here. Many traders advise the 1 or 2% rule when trading **forex** and it is fairly sound advice. However, the truth is that no two strategies are ever the same. Successful money management requires knowing your trading strategy inside out and finding the amount of risk that allows the fastest appreciation of capital whilst at the same time guarding against drawdown. Risking too much on one trade will inevitably lead to wipeout so trade conservatively at all times.