Dealing with uncertainty is one of the most important endeavors any trader needs to overcome. Since we are dealing with risk in trading there’s no actual strategy that can guarantee success 100% of the time.
That’s where risk management kicks in and because people think just about the “2% rule” when it comes to managing risk, today we’ll give you two useful principles which over time have the potential to improve your edge.
#1 Look at risk from 3 dimensions
If you already have a CFD trading account, you’ve probably managed to notice that simply risking 2% of your account per trade does not neutralize the risk of you losing a big portion of your account over time.
Alt text: CFD risk management
The reason why that happens is you are focusing on just how much you risk per trade. An effective risk management system must factor in three different variables, all of them with great importance:
- Percentage of account at risk per trade;
- Accuracy over a given period of time;
- Reward to risk ratio;
#2 Understand the risk of ruin
The second risk management principle is directly linked with the previous one and focuses on the risk of ruin formula. For those of you that don’t know, the risk of ruin is a risk management strategy usually used for gambling. However, by constantly monitoring the three above-mentioned variables, you are able to calculate the probability of you losing your entire account.
Although the risk of ruin formula might seem complex for some of you, there are calculators online which will help you determine the results. The bottom line is that you need to be fully aware of this number. Do you already know that even though you would risk 2% per trade, have a 50% accuracy (which is something usual among traders in their first few years of trading), and a reward to risk of 1:1, the probability of losing your entire account is 100%?
In this situation, you could do two things:
- Improve your strategy, so your accuracy will increase over time;
- Or much easier than that, increase your take profits relative to your stop losses, so the risk to reward ratio will increase. A 2:1 reward to risk in the above-mentioned scenario will reduce the probability of you losing your entire account to 0.
Hopefully, you’ve managed to understand the basic concepts and from now on, you will start to constantly monitor your trading performance and adjust your risk management system so the mathematics will be in your favor.