The Importance of Risk Management
The number one job of a trader is not to make money, but to manage risk. Without a solid risk management plan, even a profitable trading strategy will eventually lead to ruin. The goal is to ensure that you can survive a string of losing trades and live to trade another day. This involves defining your risk per trade and determining the correct position size.
The 1% Rule
A widely accepted rule of thumb is to never risk more than 1% of your trading capital on a single trade. For example, if you have a $20,000 trading account, you should not risk more than $200 on any given trade. This ensures that a series of losses will not significantly deplete your capital, allowing you to stay in the game.
Determining Your Stop-Loss
Before entering any trade, you must know where you will exit if the trade goes against you. This is your stop-loss. Your stop-loss should be placed at a logical level based on your technical analysis (e.g., below a key support level), not based on an arbitrary dollar amount. The distance between your entry price and your stop-loss price determines your risk on the trade in points or pips.
Calculating Your Position Size
Once you know your risk per trade (e.g., 1% of your account) and your stop-loss distance, you can calculate the correct position size. The formula is:
Position Size = (Account Size * Risk % per Trade) / (Stop-Loss Distance * Value per Point)
By calculating your position size on every trade, you ensure that you are risking a consistent, small percentage of your account, regardless of the trade setup. This is the cornerstone of professional risk management.
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