Lecture 15

Risk management.

The development of the fundamental and technical analyses methods is a necessary but not a second – order condition for being successful at the financial market. Sufficiency is achieved through the effective management of capital, which is   understood as cumulative trader’s actions, connected with risks management and money. If money management is primarily directed to maximization of making profit, then risk management – to minimize the disbenefit. Below we will consider these two aspects more details.

The control over risk is an essential part of successful trading. Effective risk management requires not only a close examination of risk proportion, but also the strategy of minimizing losses. Understanding of that how to control the risk proportion allows the newbie or experienced trader to continue the trading even when the contingent losses are arising.

As each deal is exposed to a certain degree of risk, the application of definite general principles of risk management will reduce the potential loss. Some of adopted axioms of risk control are described below and can be in use by all who has ever traded or thinks about it.

1. Do a preliminary homework.

To do the homework before the deal is a responsibility which can never be replaced. Before you exposing your money to risk, you should have a good, thought — out reason why you want to buy something that someone wants to sell. You should be clearly aware off with which financial risk you may be confronted with at any time. The part of homework includes an estimation of potential loss, in case if the market starts moving against you by 5%, 10% or 20%. Doing a preliminary homework on trade can also help you to work out the worst possible result, potential exposure to risk. You can reduce the risk, if you restrict the number of deals, to carry out the examining operation of which you can do (this is the carrying out of you preliminary homework).

2. Create a trading plan and observe it.

Every trader should create his/her own trading methodology. The methodology or trading model can be based on the fundamental, technical indicators or on a combination of both. The methodology should be tested and processed  while then it does not show the required and long-term positive result. Before you invest money, make sure that your trading methodology is reasonable and profitable. An important part of your trading plan consists in making the limits to the amount of money you can lose. If you reach this limit, come out the position. Observe your trading plan and waive the impulsive deals.

If you do not follow the plan, then you do not have it.
The trading plan helps you to identify and evaluate the key factors which have an impact on your deals and may be an important educational tool for future deals. A reasonable trading plan will also inspire you an essential sense of confidence. At the same time, it is unlikely that, having in possession a definite plan, you will trade impulsively. However, you should not blindly follow the trading plan. If you do not understand how market acts or your emotional balance is slightly broken, then you should close all positions. Creating your own trading strategy, do not invest on basis of the market advice or rumors. Your money will be at risk. Before starting to trade, do the  preliminary homework and think over your own deals verification.

3. Diversify.

Risk portfolio is reduced by diversification. Do not invest all the money in one deal. Diversify the amount of risk, trading at one position, not more than 5% – 10% of your capital assets. To be effective, the diversification must include the tools according to which you will find out the correlation (namely, how the prices of those tools are moving at the same time). If you are in a long position on  the EUR/USD, in a short one on the USD/CHF, then in fact you do not have two positions. Indeed, these tools are highly correlated (the value of their price movements are very similar), in fact you have one position with double risk. This is essentially the same as two positions on one of these markets. Closely check the relationships between all your positions, re – balance and check for errors your portfolio. Pre-determined stop-orders restrict the size of the risk and reduce your losses at the fast-moving markets.

4. Do not invest all your money.

Before finishing the deal, make sure that you have a fair capital assets to pay compensation of an unexpected loss. If a possible deal suddenly seems to be profitable, then perhaps you are too optimistic. Usually markets are rarely as good as they might seem at the first glance. If the market suddenly turns down, then it is reasonable to have certain capital in hand to compensate for modest losses or margin call. A certain capital, segregated for additional purchases, reduces stress and lowers the necessity to assume extraneous risks.

5. Use stop – orders.

-defined stop – orders restrict the risk rate and reduce your losses at the fast-changing markets. Take a strict rule of stop-loss, for example, get out of the position quickly if you lose 5% -7%. Even the most experienced traders, saying nothing of the  lucky ones, use stop – orders to limit the risk rate. Undertake the obligation to get out the trades, if your plan does not work. Stop-signals are needed to protect you. Use them when you start trading. Some traders use stop-signals according the time. If the market behaves itself as you have not expected, come out the market, even if you do not lose money. Stop-signals using in time are a reminder that you must come out from the market, if you are not sure what is actually happening at the market.

6. Trade according the trend.

It is unlikely that you will suffer a loss, if you follow the market trend. The market direction does not matter as long as you have an open position on appeared trend. If you open a failed position, then you will have to systematically reduce the risk rate.

7. Concede the error probability and incur losses.

An important aspect of risk control is the ability to admit that you are wrong and come out of the game quickly, even if it means losing money. Indeed, the best traders suffer losses from time to time. But we all hate to admit our mistakes, so it is difficult to follow this rule. The axiom is simple: let the profit bunch and reduce the losses. Try to decrease the risk rate, if the market moves against you. Do not add to a losing position, hoping to compensate for a loss. If you do not understand what the market is doing, come out the deal. Also you do not have to conclude another deal immediately after a losing one with a view to draw back the losses, firstly it is necessary to cool feelings.

8. Trade with taking protective measures.

One trader suggested a great idea about the trade in football terms: “The most important rule of trading is to play superbly in defense, but not greatly in attack.” Think first about what you can lose and compare it with a possible prize. It is better to take into account the possibility of negative events development in advance and make a plan, than to change everything after the happened fact. Always admit the idea that the market can start moving against you and be ready for this in advance. Calculate the maximum possible usage of the credit. If it is necessary, correct the stop — signal levels where it is more suitable. Create a plan of coming out from the market. So, when the market starts to move against you, you will be ready for it. Protect what you have.

9. Do not trade too much.

Reduce the risk by decreasing the amount of making deals and maintaining small stakes. Be critical to the risks to which you are exposed to. Limit the amount of deals by one of them, which is the most attractive. This forces you to do a preliminary homework and reduce the risk to make the impulsive and emotional transactions. Since the number of deals will be less, you will be more patient. Fortunately, a smaller number of transactions also reduce the amount of commission you pay.

10. Have control over your emotions.

All traders from time to time go through a severe stress and suffer losses. Anxiety, frustration, depression and sometimes despair are the part of the market trading. A part of risk management makes the ability to control these emotions. Do not let emotions control your trading. Focus on what you are doing. Trade on the basis of informed, rational decisions, instead of emotions and fantasies. Communication with other traders is one of the ways to maintain the control over your emotions. Other traders understand the challenges you have faced and can provide an important emotional support, when you have no courage. It helps you to understand that you are not alone and that others faced with similar problems and had rubbed through them.

11. If you are in doubt, close your positions.

Individual doubts suggest that there is something wrong with your trading plan. Quickly come out the market if:
– the market behaves irrationally;
– you are not sure in the position;
– you do not know what to do.

Before exposing your money to risk, you should be exactly sure in what you are doing and that you will be lucky.

The basis of risk management consists of four steps:
1) Complete understanding of the risks that the deal is exposed to.
2) The lifting of the risks that are unnecessary, if it is possible.
3) Be particular over which risks the deal may be exposed to.
4) Act quickly to reduce the risk rate, if the market moves against you.

Below we will consider the example of risk profile and managing your own funds (account), which are necessary to know by any person, who is wishing to start trading at the world financial market.

The suggested figures are only the example for an ideal deal or for a training account at its best. There can be rather different variations of suggested positions in practice. However, the planks of risk profile have to be strictly endured.

Let’s firstly examine such a question as the amount of primarily deposited funds. The traditional and the only one answer for the question about the initial sum is «the more the better». But this answer is probably not suitable as a specific guidance for opening the account. Usually the balance between the risk capital assets part (that part which you can lose) and the invested sum is 1:10.  This is a result from the general theory of west financial markets. It is correct, if you can afford it, but basically in real cases this balance is not exactly workable. The balance 1:5 or 1:3 is used more often (and more rationally). The more rational recommendation is to take the sum which you can lose smoothly as a starting point. For example, if you are ready to take a risk on approximately USD 2000, then the sum of primarily opened account can be from USD 6000 to USD 10 000. If you are ready to risk only by USD 1000, then the amount of an account will be fluctuated from USD 3000 to USD 5000 respectively, etc.

As a rule, the leverage 1:100 is offered at Forex market, the standard lots are presented in the amount of 100 000 US dollars, euros or pounds. The margin call conditions are fluctuated from 70% of  the amount of guarantee for one open position (if there are several positions, then the sums are combined) to the forced closure of positions while the amount of guarantee reduces to 3-5% of the required one. Spreads are usually formed from 3 to 10 points on base currencies and from 5 to 15 on cross-rates.

All our further calculations and examples we will speculate from the statement that the volume of primarily deposited funds comes to not less than USD 5000 and that you are ready to take risk by approximately USD 1500. In other words, you did you first  calculations:

 the amount of the account — USD 5000,
 the level of maximum losses — USD 1500.

Naturally, any changes in balances in favor of risk capital decline, for example up to USD 1000, can only be welcomed.

The leverage and margin call level.
If you are firmly intended to abide your own rules and calculations, then the leverage rate and margin call will not have such a principal meaning (it means, at opening only one position long before reaching this level). Totally, we can suggest the leverage 1:100 (standard) and margin call level in amount of 30% for our approximate account. In other words, if you have one open position at the account of USD 5000, the floating loss will come to USD 4700, you wiil be asked to deposit additional funds. The margin call level will come to USD 300. The result of the second step of calculations are the following figures:

1. the account rate — USD 5000,
2. the maximum losses level — USD 1500,
3. the leverage rate — 1:100,
4. the margin call rate — 30% from the actual balance of funds at the account.

The cost of standard lot point.

The next step consists in one point value determination of different currencies. Surely, with the change of the currency rate, the value of one point will be variable, but only changing of the course at least by 300-400 points can be considered as a significant one. One point for 100 000 in the Euro and pound contract  will cost equally — USD 10, as both these currencies have a direct quotation against the US dollar and contracts are usually quoted in the amount of GBP 100 000 and EUR 100 000. The point cost for the Swiss franc and the Japanese yen will come to 10 units of the base currency (id est, the franc or yen respectively), which then should be transfered into dollars, namely to normalize by the current currency rate.

Thereafter, the cost of one point lot 100 000 dollars against the Swiss franc will cost approximately $6, but against the Yen will be nearly $8.5. The cost of one cross — rate point is similarly calculated — 10 points of the base currency, which further transfer into US dollars.

Losses for one position — average and maximum ones.

According to the general recommendations of control over risks theory, you have to dispense the whole (maximum) sum of possible losses for your account to three entries at least. This is the theory. In practice it will be better to have to four — five ones, or to ten, if it is possible. At this step you should correlate your trading system opportunities. So, decide how close, according to the trading system signal of coming out the position with loss, will you put the stop — loss.

It is desirable to determine the amount of maximum possible loss due to one position on such high — yielding currencies as the Euro and the pound and also the amount of average loss due to one opening position on less high — priced currencies as the Swiss franc and the Japanese yen. Consequently, on the basis of our account — example we can lose at heat $375 on the average for one usual position and $500 more for the most high — yielding currencies. To be more exact, we are able to afford to lose two times by $330 — 350 and one time – $500. Considering the definite currencies it means on an average about 30 — 35 points on the pound, approximately 40 points on the Japanese yen and nearly 55 points on the Swiss franc. Assuming the maximum losses on one position, it is 50 points on the Euro and the British pound, 60 points on the Japanese yen and 80 ones on the Swiss franc. Thus, we conclude the third step of our calculations. Now we have:

–     the account rate — USD 5000,
–     the maximum losses level — USD 1500,
–     the leverage rate — 1:100,
–     the margin call rate — 30% from the actual balance of funds at the account,
–     the average level of losses on one position — USD 330 — 350,
–     the level of maximum losses on one position — USD 500.


According to the theory of risk and  capital assets management, the profit encumbered on one position should be at least 300% of possible losses (the upper limit has no fixed restrictions). Consequently, from each position we have to expect the threefold profit than the possible loss: on an average it is 90-100 points on the pound and the Euro and 120 points on the Japanese yen and 150-160 points on the dollar – Swiss franc position. In fact, having such small account it is rather difficult to adhere to proportions, so some flexibility is permissible: do not encumber the balance less than two to one. For example, the profit is appointed to be twofold more than the put stop-loss. However, according to the risk-to-reward ratio, it is better not to have experiments. In other words, it is better not to reduce below the ratio of 1:2. As a result of these calculations, we have:

– the account rate — USD 5000,
– the maximum losses level — USD 1500,
– the leverage rate — 1:100,
– the margin call rate — 30% from the actual balance of funds at the account,
– the average level of losses on one position — USD 330-350,
– the level of maximum losses on one position — USD 500,
– the minimum profit level on one position – from 600 to 700 US dollars.

At all these calculations you have to make correction on spread, on commision payment, if the position is kept for a night, which can be three times more, if the payment is for Friday, Saturday and Sunday. The main principles according to which all mentioned above base estimatings were done  should be unchanged. However, a rather wide variations of main indicators in accordance with the tactics of your trading are admitted. For example, to encumber the profit in amount of 150 points on the Swiss franc means to keep the position for two or three days.But if yoy are an intraday trader, then it is not suitable for you by no means. Consequently, the whole amount of losses can be divided to three sequent unlucky days (so, during the further three days you will bear maximum possible losses) and then — to average quantities of come in for every day. So , if you are gotng to open — close approximately 5 positions during one day, then the loss rate will be $330 — 350 per day, the losses on one position will be nearly $65 — 70. But do not forget about the profit, it should be not less than USD120 — 140. Or, for example, if you use different tactics of trading — intraday, medium — term (one, two days) or long — term ones (on week), then alloted losses on each definite operation type, keeping one — third of the whole losses sum to each activity category, then — as appropriate. You can, for example, keep one week for intraday trading and count on three — five coming in per day.

At the medium — term trading — also one week, but only three coming in etc. or add some extra rules of self — check: if during a week you account reduces three from five working days, then you will have to stop and think over where the mistake was made by you, even before the margin call or reaching the maximum losses level. There are a lot of variations. Here is like in the cookery: the recipe is one for everybody, but every person cooks in his/her own way. The main thing is not to recede from the general ingredients. The principles of risk profile and capital assets managing are the most important ones in any financial market work. As we said it the main purpose is not only to get profit but not to lose more than it was suggested. So only you can provide the safety of your capital assets and won sum of money. Otherwise, even the  luck will not help you: if you can not restrict the losses, then some sequent profit deals will turn to be a regular loss of almost all your funds in the result.

Unfortunately, wrongly or due to the lack of experience requirement, these principles usually are not paid attention to. The major traders are still consider that the main thing is to guess where the market is going to move. If you guess it will be good for you, but if you do not, then you can try to wait for, may be the market nevertheless will move to the right side? Unfortunately, you have not hope on the off chance in a real life. The main part of trader’s work is not to admit the worst. Naturally, that you have to care of these and other troubles in advance. And if the market maves against you (this will take place very often), then you will be more  peaceful to know that the worst thing you have previously provided.

The plan of managing you capital assets will bring you the profit only then when you do that it dictated you to do. This means, that it is necessary not only to carefully plan your deals, as it written above, but to trade according this plan. if you reach the stop — loss price, then you have to admit this stop. If you found out that your trading system steadily gave you stops, which worked, then possibly you had to overview the system rules. Other way you will be forced to absorb bigger risk than it was planned, enhancing the chances that a bad trading system will lead you to collapse. Accept the losses when they are small, otherwise they will become big. Here the great significance has the discipline. It is worse if the market will turn and make the deal profitable, as now you are psychologically ready to make new mistakes. Quickly come out and overestimate the situation. If you suggest that it can turn, then open a new deal with a new stop. The faith, hope and prayers leave for God, indeed markets are false and unsteady idols.

Assignment for submission.
1. What does it mean to manage the capital assets?
2. What are the fundamental principles of managing the capital assets?
3. What should be understood by the definition «risk rate»?
4. According to your rules on managing the capital assets, the risk on one deal can be not more than 5% of the general sum amount. The account comes to USD 5000. At what distance (how many points) from the opened position should the stop — loss order be placed, if the price of a point is USD10?
5. According to the rules on managing the capital assets, you can involve not more than 20% of available funds in one deal. You have USD 5000 on your account, a fixed margin call — 1000 on one lot, the leverage 1:100. Which maximum lots volume you can afford yourself on opening the position?

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