Controlling the risk of your Forex trading positions

Controlling risk is one of the most important factors of successful trading. While it is emotionally more appealing to focus on the upside of trading, every trader should know precisely how much he is willing to lose on each trade before cutting losses or ceasing trading and re-evaluating his strategy.

Trading financial instruments implies risks and depending on the instrument there could be also instrument-specific risks, that should be monitored or managed. Risk will essentially be controlled in three ways: 1) by exiting losing trades before losses exceed the pre-determined maximum tolerance (or "cutting losses"), 2) by limiting the "leverage" or position size you trade for a given account size, and 3) by keeping a good diversification of the structure of the investment portfolio.

1. Cutting Losses
Almost all successful trading strategies include a disciplined procedure for cutting losses. When a trader is down on a positions, many emotions often come into play, making it difficult to cut losses at the right level. The best practice is to decide where losses will be cut before a trade is even initiated. This will assure the trader of the maximum amount he can expect to lose on the trade.

The other key element of risk control is overall account risk. In other words, a trader should know before he begins his trading endeavor how much of his account he is willing to lose before ceasing trading and re-evaluating his strategy. If you open an account with $10,000, are you willing to lose all $10,000? $5,000? As with risk control on individual trades, the most important discipline is to decide on a level and stick with it.

2. Determining Position Size
Before beginning any trading program, an assessment should be made of the maximum account loss that is likely to occur over time, per position . For example, assume you have determined that your worse case loss on any trade is 30 pips. That translates into approximately $300 per $100,000 position size.

Further assume that the $100,000 position size is equal to one lot or contract. Five consecutive losing trades would result in a loss of $1,500 (5 x $300); a difficult period but not to be unexpected over the long run. For a $10,000 account trading one lot/contract, this translates into a 15% loss. Therefore, even though it may be possible to trade 5 lots/contracts or more with a $10,000 account, this analysis suggests that the resulting "drawdown" would be too great (75% or more of the account value would be wiped out).

3. Diversification
In order to reduce overall risk of an investment portfolio the diversification of the assets shall be improved. There are three strategies to reach this target: 1) spreading the portfolio among multiple investment vehicles, 2) varying the risk of securites by diversifying into different investment strategies, 3) varying securities by industry and/or geography.

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