In this article we look at different approaches to Risk, including risk adjusted returns, and how these all prioritise seeking profit whilst ensuring you stay alive. Risk management is often seen as an unglamorous subject which stops the big boys from making money. Terms such as risk-based approach, risk adjusted returns and the risk-reward ratio are all actually trying to get you to do the same thing! Earn a profit whilst mitigating your risk.
With a risk-based approach, your are evolving your process to be one where your first consideration is the how much risk you are taking, rather than how much profit you will make. This means finishing each day not counting how much dosh you made but how much you avoided losing! Do that and the profit will look after itself.
With risk adjusted returns, your return is based on only putting a certain amount of capital at risk to ensure a profit. That means you actually calculate how much capital you are putting at risk. This is performed using such volatility metrics as standard deviation or Value at Risk. Although this is beyond what most Forex traders will need, it is useful to be aware of it. These metrics are most often used by large banks to calculate how to assign their capital in the most efficient way possible.
An area where the retail Forex trader can adjust their risk, is through their position sizes. We recommend only taking 1/2% of your portfolio as the absolute maximum in any given position. Although your profit may be small, you are also ensuring that your loss is smaller if the worst happens. How can the loss be smaller you ask? Another risk adjusted returns approach can help…
The risk reward ratio is one of the key risk processes that any retail Forex trader should use. Anyone looking to trade Forex will by definition be looking to buy at one level and sell at another. The risk reward ratio allows you to quantify your risk and insist that the opportunity will produce double the profit for the risk you are taking. This is achieved by using stop losses, where you will set these up so as to have a minimum twice the profit than the risk you take. This method is akin to set and forget. You are setting up your trades and forgetting about them. You can do this while safe in the knowledge that your stop losses will trigger if your profit target is met, or if the trade is going beyond the capital you are prepared to risk. This ratio should be used by all aspiring Forex traders due to its simplicity and for its contribution in making you a consistently profitable trader.
The biggest risk that you need to manage is you! You are the one in control of the mouse which hovers over the buy button. When you reached that stage is it because of a well-thought through plan? Are you following the rules set out in your Forex trading plan? As the key actor in the opening and closing of positions then managing yourself is critical. Specifically your emotions. Letting a high or a low influence a trading decision will usually lead to a loss. Trusting your Forex trading plan and following its outline will ensure that you cut these mistakes out. Developing this discipline to negate the effects of your emotions whilst focusing more on the cold hard facts are what will ensure your Forex trading success.
As we are not puritans we cannot tell you not to take a risk. We are suggesting taking a calculated one. Leverage is an area which we recommend staying clear of. For those who get it right, then a big pay-day and usually over-confidence follows. How many people who were fantastically successful once are able to replicate this consistently? Learning to make small regular profits will soon ensure that you are able to grow your account consistently. This will be achieved without the stress of taking out-sized positions.
Any trader is a actually a risk manager first. Applying processes such as risk adjusted returns will not stop you from trading but will alter your approach to Forex trading. From taking large risks which usually result in large losses, you will learn to take small ones and make regular profits. Soon enough the accumulation of regular gains will lead you to growing your account into giving you extra income! Trading profitably is possible for all using risk adjusted returns!