For many new forex traders, the promise of quick riches is difficult to resist. That is the main reason why every day, so many people from all walks of life begin trading the forex market. While some element of this “keep your eyes on the prize” mentality is necessary to get traders through the tough times, on any given trading day one should really focus on other things first. When contemplating any kind of trade set up, a trader MUST understand that no matter how perfect the setup is, it is possible for something to go wrong and the trade may end up being a loser. Thats ok it happens to everyone. Inherent in the forex market is a certain degree of randomness. That is not to say that the market is completely random it isnt but it is so complex that a certain degree of randomness must exist. It is simply not possible to have all the information that all market participants are reacting to, or to predict how any of them will react to said information. Moreover, this randomness is necessary for the proper functioning of any financial market: If everyone knew the direction of the market, then there would be no market – a market depends on there always being a buyer and a seller. The randomness cannot be eliminated, but it can be managed. So back to our perfect setup that failed: how could this have happened? Well, as luck would have it, as a part of its quarterly internal accounting procedure, some random multinational corporation just happened to be buying the currency that you sold, driving up its value that is, moving the price against your position, and triggering your stop loss order. If you were smart, and you managed this randomness, or risk, in a logical manner, you can take the loss in stride and live to trade another day. This is just a part of what every trader may have to go through on any given dog-day afternoon.
So how do you manage this “risk”? There are volumes of books written on the subject, and there are many different methods to accomplish this, but really what we are talking about is “how much are you willing to lose on this trade if it goes against you?” The answer should come from your money management rules, which are a slightly different topic (we will discuss this in an upcoming article). Suffice it to say that most traders live by the rule that no more than 1-2% of your account should be risked on any one position. What we are dealing with here then, is how do you make sure that you only risk x% of your account? What many novice traders believe is that you should use x% of your margin on every trade, but that is EXTREMELY DANGEROUS and not in line with proper risk management. The reason is simple: such a calculation does not even take into account your trade setup. If you are placing a long-term trade with a 1,000 pip stop loss, you could very well be facing a margin call long before price reaches your stop loss level. On the other hand, if you are placing an intraday trade with a 15 pip take profit, then your profit will be insignificant. There must be a way to take into account your exact trade setup and to choose your position size accordingly. The trade setup must determine position size, NOT the other way around! This is one of the most critical aspects of retail forex trading, and many traders simply dont get it (or dont care). Lets illustrate this with an example:
