Forex Guide

I can recall many moons ago reading an article regarding the success rate of forex traders. I don't know how factual the figures where, or where the person who wrote the article obtained the figures from, but I do remember the figures presented. Initially it came as a surprise, but considering my own track record when I begun trading the forex market I didn't doubt the facts bites you back and its not long (around 3-6 months) that you find yourself glaring at an account balance below the amount available to buy one contract.

Just recently I decided to write up a quick article on what I thought was the number one determining factor personally. In this particular article it stated that about 90-95% of forex traders lose their capital within the first 3-6 months.

Now, everybody who opens up a forex account believes they will be the 5-10% of traders who super-naturally just happen to make money with the small amount of experience they have. I know I did! But this mild sense of arrogance of why 90-95% of forex traders lose their shirt within their first 3-6 months? After looking at my own starting performance and reading around the forums and talking with forex friends I think I have found the number 1 reason.

And here it is...

FOREX TRADERS FAIL TO TRULY UNDERSTAND THEIR RISK

I know I know, you've heard it before right? And you've been to all the special risk management classes and read all the money management books, visited all the risk courses on the internet, etc etc, but please read on.

See, I thought I knew all there was to know about risk, and I thought the skills that I had acquired from the stock market were easily transferable to the forex market. I mean, how complicated can understanding risk be? Isn't it just what we can lose from our trade? Well, lets make sure we are all on the same page with the definition of risk...

While we might all have our own different interpretations on what risk means, I personally define it as being the amount that can be lost if our stop were hit once our trade is transacted.

As an example: If I were to buy 10 EURUSD contracts at 1.2401 and were to place a 20 pip stop I would lose 10 x $10 x 20 = $2,000. The equation variables are: quantity of contracts x value per pip per contract x distance of stop price from opening price. Therefore, we were willing to risk $2,000 on that trade.

So our risk is defined as the initial amount we are willing to lose when we place our trade. With this understanding let us know see why so many budding forex traders fail to truly comprehend it.

Forex Trading Risk Questionnaire:

Answer these questions about your forex trading experience to gauge your understanding of risk in the forex market:

Do you use stops? Yes/No
Do you know how much you are likely to lose in a trade if it happened to go wrong immediately after the trade was transacted? Yes/No
Do you know how much you are risking as a percentage of capital per trade? Yes/No
Do you place similar orders in the same direction on different currencies? Yes/No

If you answered "NO" to the very first question, I would hate to think of the excuses you use to justify not using stops. Here are some reasons that I have come across from people who do not attach stops to their orders:

My broker is out to get me (SOLUTION: Either change broker, or place a stop that is ridiculously way outside where you would get out, then hit close trade when it hits your stop point)

I use entry stop reversal orders instead (be very careful with this method as FXCM has certain restrictions on this)

I use mental stops (I would hate to be around your place when the computer, electricity, internet or certain body organs need emptying... place a ridiculously far stop anyway, then hit close trade when it hits your stop point) I'm a man... I don't need stops (I can't help you here... maybe surgery?!)

If you do not employ stops in your trading then you have very lax risk management principles, and if you happen to wipe out within 3-6 months representing another statistic then I would strongly recommend that you re-think your stop loss part of your trading plan.

If you answered "NO" to the second question, then either you do not use stops (see the two paragraphs above), or, you do not know how to calculate your risk. If you would like to know how much you are risking then use this simple formula:

Quantity of Contracts x Value per Pip x Loss in Pips

As a quick example: If you bought 7 EURUSD standard contracts and had a 16 pip stop loss, then your risk would be 7 x $10 x 16 = $1,120. A standard contract is where each contract uses $1,000 in margin per contract. If you use a mini contract you will notice that each contract requires you to have $100 in margin per contract (the "Value per Pip per Contract" variable would be worth $1 in the above example and your risk would only be 7 x $1 x 16 = $112).

If you answered "NO" to the third question I would assume that you either thought it was of little importance, or did not know how to do it. If you do not know how to calculate it just use the formula above (Qty x Value per Pip x Loss) and divide that result by the amount of capital you have.

So why is risk as a percentage of capital important? I have read many times before that the optimal risk percentage is about 2% per trade. If you find yourself wiping out often it could be due to the fact that you risk far too much per trade. Knowing your risk percentage can also show you what amount of consecutive losses you can take before you wipe out. The calculation is below...

To find out how many consecutive losses will wipe you out divide 100 by your risk percentage. As an example, if I were risking 4.5% per trade it would only take 100 / 4.5 = 22 consecutive losses until I was wiped out. If you are backtesting a system you might want to check the number of consecutive losses your system has had in the past and then make sure that the systems string of losses is less than the calculated figure above.

The Hidden Risk

The last question brings it all home. Even if you think you have mastered risk by successfully answering all the above questions, you may still find yourself wiping out. The reason for this is due to the correlation between the currencies you trade.

It should come as no surprise to you that the EURUSD and GBPUSD currencies move in similar fashion, likewise the EURUSD and USDCHF in a mirrored fashion (when one moves up the other moves down). This relationship is known as a correlation and can be measured statistically. If the correlation between two currency pairs is above 0.90 then they are said to have a "strong correlation". Conversely if the correlation between two currency pairs is below -0.90 then they are said to have a "strong negative correlation" (when one moves up it is more than likely the other will move down).

This high correlation between currencies can blow your risk by at least twofold and as much as threefold if you trade the EURUSD, GBPUSD and USDCHF in a similar direction.

I once analyzed the correlation that existed between the currencies and found some amazingly high correlations (even between currencies I really didn't think had much of a correlation). As you can see from clicking the link below the chart highlights some of these strong correlations.

Daily Forex Correlations

The warning I would like to make is that if you find you are placing similar trades on two different currency pairs you are doubling your risk! Instead of risking the initial 2% per trade, you are now actually risking 4% per trade! Instead of 50 consecutive losses wiping you out, you only now have 25! I hope you can see the importance of this.

What to do? First of all recognize the problem and do one of two things: Decrease the quantity of contracts for each trade that has a high correlation (if you are trading the EURUSD & the USDCHF halve the quantity between both), or Only trade one currency. Reducing your risk can be as simple as that.

I hope this lesson has impressed on you the importance of risk in the forex market. It's not just a case of knowing what your risk is, but knowing that there exists a high correlation between currencies and that by doing similar trades you can be doubling or even tripling your risk. Don't forget the first rule in trading: Protect your capital at all costs. Managing your risk safely will help you achieve this.

by currencysecrets.com