Monday, February 25, 2008
The Risk of Risk
I have recently become aware of why only risking 2-5% of total account balance on any one trade is vital. Rather then trying to explain the theories behind having controlled risk on trades I have linked readers with a small excel sheet to show the results graphically. The results show that using a risk ratio which is too high will almost always lead to the account being bankrupted. Download it and run it for yourself.
Matt Bowen over at mptrader.com has written a great little excel sheet the shows why having appropriate risk controls are important. Download it here and have a play with it: http://www.mtptrader.com/MoneyExpert.xls
If the excel sheet seems a bit confusing and you can't figure out how to use it; this video should explain it easily:http://www.mtptrader.com/videos/MoneyExpert.html
After playing with the risk variable it should be noticeable that the rate of account bankruptcy dramatically increases above 5%. At 10% risk exposure per trade it is more likely then not you will blow your account, unless returning a good amount of timely winning trades.
Why is this the case?
Effectively by having a high risk ratio the trader is trading too large a quantity of currency. That effectively is making the trader 'under capitalised' for the position he is taking. The problem with under capitalisation? - it reduces the Trader to that of a gambler and the gambler's ruin problem (http://en.wikipedia.org/wiki/Gambler's_Ruin
) whereby the participent in the game with the most money (the market) send the other player (the trader) broke.
From these two observations I have strictly limited myself to exposure of 2% on any given trade.
I check out this website to help you calculate how many lots I should purchase given the currency, account balance and stop loss level http://www.forexcalc.com/
I have used this for the basis of my calculations for position size.