What is risk? Trading risk management explained

When new to trading, there is a lot of different theories you need to grasp. However, risk management and some key concepts in this area are crucial to master before you get started trading with live funds.

This article is a comprehensive guide for calculating position sizes when trading forex, indices, commodities, and stocks.

This article is part of a new series:

"Day trading school - learn to trade with Rookie".

Glad to have you on board!

Please comment at the bottom of the article if you have suggestions for future topics in the series or you just have something to add to the article!

What is risk and why is it important when trading

In financial terms, risk is defined as the possibility that your financial investment will not be profitable and the outcome will be different than expected. In other words: Trading involves a level of uncertainty - you could potentially lose some, or all, of the invested capital. 

This is probably easily understandable by most people. Trading carries a risk of losing money, and trading volatile assets will exaggerate the risk!

What is less straightforward for most, is how to manage the risk and avoid taking unnecessary risks when trading financial assets.

Well, if we want to manage risk, we need to dig deeper and quantify the level of uncertainty. We need a way to be able to precisely measure the risk surrounding an investment or a trade.

Always trade with a stop loss

There are different ways to manage risk when it comes to trading. Some strategies like hedging are quite advanced, and probably not even too relevant in most markets. 

For anyone new to day trading, there is only one appropriate solution: Always trade with a stop loss and only risk a set amount of your account size on each trade! 

And, this option is probably also the only right way to go about it for 99% of everybody else. But you might have heard about traders that don't use a stop loss when trading? They might be afraid their stop-loss order is being "hunted" or other similar arguments. I won't go into more detail than saying: Use a stop loss at all times and save yourself from a lot of frustrations and losses! In my opinion arguments against using stop-loss orders simply aren't valid, anyone day trading for a living will tell you risk management is a key foundation to success! 

One huge advantage of using stop-loss orders is how you will be able to precisely estimate the amount of risk you put on in every trade. I am deliberately writing "estimate" because you may experience slippage and re-quotes some times, making your loss larger than estimated.

Risk-reward-ratio explained

You may have heard a saying:

"Cut Losses And Let Winners Run"

Well, in praxis: If a trade-setup is going against you, it is generally best just to get out in a small loss and wait for the next setup to develop.

But if the trade is going according to your plans, you should generally wait for the setup to develop and the price to reach your target before taking profits. But, this really can vary quite a lot depending on your strategy. 

When evaluating if a trade is worth taking, a lot of traders use a number called risk-reward-ratio. This is a ratio that explains the proportion

between the risk taken (standardized to 1) and the potential profit if the trade goes to the planned target:

Visual presentation of risk-reward-ratio 1:3

In the above example, the risk-reward-ratio is 1:3 - meaning the distance from the trade-entry to profit is exactly 3 times larger than the distance from the entry down to the stop-loss. This example is straightforward, but most times you will be working with odd numbers. The ratio can then be calculated using this formula for both long- and short trades:

calculation of risk-reward-ratio on a black-board

When planning a trade you should start by finding a potential entry point. The stop loss will then be placed according to your strategy and trade-plan. A lot of traders will place the stop-loss where they consider the setup "invalidated". Others use something like ATR which is shorthand for Average True Range: a measurement for market volatility. This is then used to determine when price movements are a part of normal volatility, and when the price is going against you. 

Let's take a look at how the above 1:3 risk-reward-ratio could look like in a real-world scenario:

In this example, the trader has noted a strong bullish trend in the market and is looking for a pullback to get into a long trade. The stop loss is placed below a previous swing low, with a bit of extra room to avoid getting stopped out by normal market volatility. 

In this example, this was the right strategy, as the price is going lower than anticipated on the pullback. Luckily the EURUSD did not take out the stop-loss order before moving to the take-profit target. So this example is a winning trade, and a profit 3x larger than the risked amount is realized.

How often can I get stopped out and still be profitable?

Even the best trading strategy will have a fair amount of stop-outs where the stop-loss order is hit and a loss is realized. This is part of the trading strategy: a single trade should be executed as a part of the overall context and evaluated as a part of the strategy.

So, your strategy could either go for a very high win rate, taking profits fairly early - or in the opposite direction going for a few large wins and getting stopped out on more trades. 

Of course, most strategies will be placed somewhere in-between the two extremes where you will try to find a sweet-spot not taking profits too early, but still not waiting long enough to avoid getting too many stop-outs (taking partial profits can be a great strategy on many occasions). 

If you stick to a fixed risk-reward-ratio, it is possible to calculate the required win-rate:

calculation of required winrate to be profitable from risk-reward-ratio

When looking at the table, it becomes apparent that you actually can have a fairly low win rate and still have a profitable strategy. 

As an inexperienced day trader, it can be difficult to guesstimate what is realistic in the long run. 

From my personal experience, I would say that a win rate of 75% with a low risk-reward-ratio is way harder to achieve (read: nearly impossible) than a low win rate and higher risk-reward-ratio, but this is going to be highly dependant on the market(s) you are trading. 

It is also important to note that the required win rate is the win rate required to brake-even on your trading account. To be a profitable trader you need to do better than that to make sustainable profits on your trading account.

Let's say you trade wit a risk-reward-ratio of 1:2. The required win rate is then 33% or in other words: You need to reach your target in 1 out of 3 trades. 

If you have a historical long-lasting streak of trades where your win rate is 50% when trading with a 1:2 risk-reward-ratio - then you have a profitable trading strategy: voila!

A few words of caution: On most occasions, a strategy with a fixed risk-reward-ratio isn't desirable. The required win-rate is better used as a theoretical basis to understand the relation between risk-reward-ratio and how often you can "afford" to get stopped out and still have a profitable trading strategy.

How much to risk on every trade?

When day trading the overall objective is to compound a lot of smaller wins into growth. This is why you need to learn that taking a few losing trades here and there is a major part of your trading strategy. 

Most people new to this game simply do not understand how incredibly forceful the compounding effect is. Day trading is a slow build of wealth that relies on steady work ethics to be effective.

Something really important when trading, is to pick the correct risk amount.

This will ensure your trading account doesn't take large hits if (when) you hit a bad streak of trades with continuos stop-outs.

There isn't a "one size fits all" solution to position sizing, but the consensus amongst most seasoned traders is risking 1-2% of your trading account on every trade.

This problem is, that if you go larger, a streak of stop-outs will accumulate to a larger drop in your account size.

I am not afraid of dialing back my risk to 0.5% if I hit a bad period. This will allow me to trade calmer until I get on top of things again.

And then we need to eliminate a couple of misconceptions that I have read from a lot of people new to trading:

  • Risking 2% on trades does NOT suggest you trade with 2% of your trading account. It implies you are trading with a position size so IF you get stopped out, you will take a loss equivalent to 2% of your current trading account balance.
  • Leverage does not affect position size calculations! You do not take an inappropriate amount of risk because the leverage is too high. Your risk will be too high because of trading with positions sizes that are too large.

With that out of the way, let's get to the point and learn how to calculate position sizes in different markets:

Lots or units?

The overall approach when calculating position sizes is very similar for all markets, but there are some important differences. 

In the following sections, I will teach you to calculate position sizes when trading forex, stocks, indices, and/or commodities (as futures or with CFDs). 

It's important to distinguish between calculations for positions in lots or units. If you enter position sizes in lots or units depends on your broker and the trading software/platform you use.

Most notably forex can be a bit more complicated when it comes to position sizes - so let's get that out of the way first! 

Forex pairs explained

First off, you need to understand precisely what a foreign exchange rate or forex pair is. A forex pair consists of 2 different currency pairs:

EURUSD currency pair consist of basecurrency and quote currency

In this example, we will look at the EURUSD or the European euro against the United States dollar. The current rate for EURUSD is the price it will cost you to buy 1 EUR if you pay in USD. 

The left-hand pair is the base pair (also referred to as the transaction-pair). You could say it is the "base" of the transaction - it is the currency you want to buy.

The right-hand pair is the counter- or quote currency. It is the pair you quote the currency against or the currency you already own. 

PIP value calculation in FOREX

Before calculating any forex position sizes, we need to know the PIP value for the pair we want to trade. PIP value calculation is something that often confuses new forex traders. It isn't that difficult really, but it does involve a little getting used to, and there are some pitfalls to avoid.

When your account currency (this may also be referred to as "account denomination") is identical to the counter-currency the PIP-value is calculated by multiplying the PIPsize with the lot size. 

As 1 lot is always equal to 100,000 units when trading forex, the PIP value is 10 for most forex pairs (as most forex pairs have a pip size of 0.0001) with the most notable exception of JPY-pairs with a PIP size of 0.01. 

So let's say your trading account is funded in USD and you trade the EURUSD forex pair. 

Well, then the PIP value for 1 LOT is simply 10 - Easy peasy!

When your account currency isn't identical to the counter-currency, you need to factor in the exchange rate to get the PIP-value and things get a bit more complicated.

I have seen different ways to calculate the PIP-value, but I prefer the calculation shown on the board below, as it only involves one formula when the counter-currency is different than the account currency:

calculation of PIP-value on forex pair on blackboard

To get the calculation right, it is important to use the correct exchange rate. As shown on the board, you combine the account currency with the counter currency to find the correct exchange-rate.

As an example: A trade on the USDNZD forex pair (United States dollar against the New Zealand dollar) from a trading account denominated in Euro you would need to insert the current exchange rate for EURNZD.

Calculating position sizes

Finally, we get to calculating the position size. And the formula is similar when trading forex, futures, CFD's (Contracts for differences), or stocks.

calculation of position sizes on trade-pairs on blackboard

The Gold example on the board above requires a bit of elaboration: Gold is mostly traded in lot sizes of 100 troy oz. 

Troy ounce is an old unit of measure still used for weighing precious metals today.

As you see on the board above, the only real difference between trading something like Gold and Forex is that you call it points or ticks instead of PIPs.

One tick is the smallest possible price change - very similar to PIPs in forex. And that is even a bit deceptive as most brokers will show one additional digit.

TIP: If you chart your setups on TradingView you can always look up the point- and tick size on the stock under symbol info.

In the upper left corner hover the name of the trade pair, click on the 3 horizontal aligned dots appearing on the right side, and select "symbol info" in the menu.

How to open symbol info when charting on TradingView

Contract size, however, is less standardized and can vary a bit between brokers on some products, so this is something you will have to get from your broker platform.

Furthermore, you need to calculate the tick-/point-value in the currency of your account.

So if you are trading something like the North American Stock index S&P500 on your Euro funded trading account - you need to divide with the current exchange rate for EURUSD (take a quick scroll-back to the PIP-value board if this is still a bit unclear. 

Calculations for stocks

So, what about stocks? Well, day trading stocks aren't much different than trading anything else, and the calculations involved are similar.

The principle is the same as calculating position sizes for futures or CFD's - or the same as in the Gold example on the board above. As there are no contracts, and you simply buy single stocks, calculations are a bit simplified - here are a few examples:

calculation of position sizes on stock pairs on blackboard

When the stock is traded in the same currency as the account currency as shown in the Tesla example, you do not calculate a point-value as all values for the calculation are equal to 1 and the point-value, therefore, is simply $1.

When the stock is traded in a different currency than your trading account, see the Facebook example, you need to include the exchange rate for EURUSD. You might wonder if leverage trading stocks makes any difference: It does not!

As explained earlier, leverage doesn't change anything about position size calculations. Leverage merely gives you more buying power - use it wisely!

Do I need to calculate position sizes on every trade?

Yes! To maintain proper risk management you need to calculate position sizes on every trade you take - this is something I will highly advise going forward.

But, of course, you don't have to calculate every position by hand - an online position size calculator is indispensable when trading. But to avoid making obvious mistakes when calculating position sizes, I think it is advisable to familiarize yourself with the calculations explained in this article. 

Learning the basics of position size calculations is an important lesson to learn for anybody serious about day-trading in any market.

I have developed a free position size calculator that will calculate anything you need when trading any forex-, commodity-, or index pair.

This is a free browser extension available for Google Chrome, Microsoft Edge and Opera desktop internet browsers:

Check it out: 

HereRookie's hand pointing left

I hope you enjoyed this walk-through and now feel confident about taking your risk-management to the next level!

Anything you didn't understand or does something feel unclear to you? Why not write a comment below?

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