This is a guest post by Ahmad Hassam
Bad risk management can create stress and ruin your forex trading career. You might have the best forex trading system in the world but it will fail if you don’t practice good risk management. Losses are inevitable with any forex system. But what if you have bad risk management? You will blow out your account soon and most probably don’t have enough money to make those profits that you had dreamed when you started trading forex.
Bad risk management is one of the main reason that fails the budding career of many new forex traders. Many people start trading forex dreaming of making a million in just a few months. They overtrade, take on too much risk and get blown out by the market.
Many buy a great forex system, make a few trades that are way too big for their equity in the account. When the first few of these trades go wrong, they lose almost all their equity. After this they think that forex trading is a lie and quit.
What is more important for you? Capital preservation or capital appreciation? Of course capital preservation. Learn to survive the market and trade another day. Suppose, your system makes only 10% return per month with a risk of only 1%. Is it better or is this system better that gives a 50% return per month with a risk of 10%. Naturally the first one is a better system. Let me explain.
Suppose, you have a coin and you have $100. Your friend want to bet $10 dollars for every flip of the coin. You and he agree to make 1000 flips. Ideally if you win all the 1000 flips, you will be making $1000. But if you lose all the 1000 flips, you lose $1000. But you have only $100 in your pocket. So, how much maximum to bet on one single flip of the coin?
If you bet $10 on each flip, you will have 90% chance of getting wiped out in 1000 coin flips. In those 1000 flips, you just need 10 losing flips to lose your $100. So, what to do? Let’s say, you tell your friend that you are ready for the bet but with only $1 per flip.
Now, what are your chances of losing all your $100? Only 5%. You see, you need 100 flips in a row to lose $100. This makes your risk of losing only 5%. This is exactly how you need to take the game of trading.
It is risk management that is going to determine how fast or how slow you grow your equity. Your equity can grow very fast if you take too much risk but you might as well get blown out soon too. On the other hand, take too little risk, your equity may grow slow but you have very little chance of getting wiped out. Whatever, you need to understand that it is not the pips that you make that determines how much you make with a forex system but risk management that determines how much you will end up making with those number of pips.