If you are wondering how much to risk per trade, then this post will show you exactly how to figure it out.
…and it probably isn’t what you think.
First, let’s get some conventional wisdom out of the way.
I’m sure that you have read all of the articles and books (like Market Wizards) that say that you shouldn't risk more than 2% per trade.
Some call it the 2% Rule.
As a general rule of thumb, it’s actually great advice. It will keep most traders out of serious trouble and help them hang around long enough to learn how to trade profitably.
But is the 2% rule optimized?
Not by a long shot.
If you don’t risk enough per trade, you aren’t maximizing the earning potential of your trading system. Risk too much and you can hit a drawdown that will have irreparable negative long-term effects on your trading psychology.
As traders, we want to avoid both of these scenarios. This is why you need to optimize your risk per trade.
Let’s start by taking a look at why 2% risk is far from optimized.
Why the 2% Risk Rule is Not Optimal
Again, the 2% Rule it is a good guideline that will keep most traders out of serious trouble. But it’s probably not ideal for you and your trading strategy.
These statistics need to be taken into account when figuring out how much to risk on each trade.
- Your win rate
- The percentage drawdown that you want to avoid (AKA your Freakout Point)
- Your average win/loss ratio
Without these stats, you are shooting in the dark.
The most important one to have is the drawdown that you want to avoid. Most new traders dream of the millions of dollars that they can make in trading.
But as most professional traders will tell you, focusing on the amount that you can lose is much more important.
If you hit a drawdown that screws with your head, you will go on tilt and possibly lose your entire account. At the very least, you will not trade well until you get over the loss.
So your long-term success absolutely depends on knowing your “breaking point” and that comes from knowing your vital statistics.
How to Figure Out Your Vital Statistics
Luckily, it is easy to figure out these numbers. Here is how to get each of your vital statistics.
Maximum Tolerable Drawdown
The best place to start is the maximum amount of your account that you want to avoid losing.
How do you do that?
It’s pretty simple…
First, imagine a trading account that would represent “a lot of money” to you. This will be different for everyone, so use a number that works for you.
For example, let’s say that $10K is a lot of money to you. Since that is a fairly big account balance for most people, we will use that number in the following exercises.
Now ask yourself how much of that account you would be willing to lose before you start freaking out.
In a $10K account, you might want to stop trading when you lose $2K, or 20%.
That is your maximum drawdown number.
I would actually suggest shaving little off that number, so you have a cushion. This is in case you are hit with some slippage or you fat-finger a trade.
So in this example, you might want to use 18% as the maximum drawdown that you want to avoid.
Once you have this number, it’s time to figure out the other two stats that you need.
Next, you need to know the win rate for your trading strategy. If you have been trading in a live or demo account for awhile, then you can use your current win rate. You should have at least 20 trades or so, to have a valid win rate.
But what if you are not consistently profitable yet?
No problem, simply put your trading system into Forex Tester and backtest it. That will give you a very good idea of how your strategy will perform.
Of course, your live trading performance will not be exactly the same as your backtesting. But having a number that is pretty close is much better than guessing.
For this example, let’s say that your system has a 62% win rate.
Your Average Win/Loss Ratio
Finally, take your average winning trade and divide it by your average losing trade.
To make things simple, let’s say that your average winner is $56 and your average loser is $28. That would give you a ratio of 2.
Again, if you don’t have live trading results, backtest in Forex Tester to get these numbers.
Now that you have the three vital statistics, you can plug them into the drawdown calculator to figure out how much to risk per trade.
How to Use the Drawdown Calculator to Figure Out How Much to Risk Per Trade
Here’s the moment of truth…
Head on over to the drawdown calculator, located on this page. If you want to use the example stats mentioned above, here is what the calculator would look like.
In this example, you would have a 8.4% chance of hitting a 18% drawdown over 1,000 trades, when risking the recommended 2% per trade. That’s not terrible.
…but it is still very possible.
Keep in mind that your exact result will probably be a little different from my answer because the calculator runs a new simulation each time you click the Calculate button. If you click the button a few times, you can see the range of probabilities to expect.
But let's see if we can get that 8.4% to absolutely zero.
Start playing with your risk per trade until you find a point where your chance of hitting your drawdown is absolutely zero. Click the Calculate button a few times, just to be sure. I would suggest using up to two decimal places for your risk per trade.
With the numbers mentioned above, you would need to risk 1.22% per trade to have a zero percent chance of hitting an 18% drawdown. Now you have the exact amount that you need to risk per trade, to avoid your most feared drawdown, while maximizing the return of the trading system.
But only 1.22% per trade?
Is that really enough?
What if the Risk Per Trade is Too Small?
Chances are pretty good that you will come up with a risk per trade number that you think is too small to grow your trading account significantly.
This is a common mistake that traders make.
They either throw out a perfectly excellent trading system because they think the risk is too small, or they disregard what the calculator says and risk way too much per trade.
Both of these actions usually lead to frustration and a ticket to ride on the Trading Silodrome.
So what can you do to build your trading account faster?
Remember that our friend compounding can help us increase our gains much faster than we might realize.
To see a perfect example, read this post.
When you are able to find a system that is consistently profitable, then you can simply trade it on more currency pairs. Of course, this is provided that your testing shows that it will work on the other pairs too.
You can also test other trading systems and if the results of your testing are good, you can start trading those systems too.
Lather, rinse and repeat until you reach your trading goals.
By layering trading systems and currency pairs, you multiply your trading edge. This can make a seemingly insignificant advantage pay out very well.
If you are just starting out, then risking no more than 2% per trade is a good place to start. In fact, keeping your risk down to 1% is even better.
However, if you have a technical trading strategy that can be backtested or you have a good amount of live or demo trading results, then using the Drawdown Calculator to optimize your position sizing will be a huge help in keeping you out of a heart-crushing drawdown.
Success in trading is all about sticking around long enough to take advantage of excellent trading opportunities. You cannot do that if you lose your account…or your mind.
Figure out your ideal risk per trade beforehand and your trading will be much less stressful.
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