Risk Management: Back To Basics

August 8, 2008 will be a day no FX trader should ever forget as the EUR/USD made an unprecedented move. Never in one 48-hour period had the euro ever lost so much to the dollar.

With a historic move of that proportion comes some lessons, a few of which are painful and expensive for many traders. By Friday afternoon there was a lot of slow singing and flower bringing as many traders flat out could not survive a move like that.

I heard some of the horror stories from several traders who were brave enough to reveal they suffered a margin call. I spoke with somebody at FXCM and she told me the margin calls, in terms of dollar amounts, totaled in the 8 figures. I’d be willing to bet it was even higher than that.

I rarely allow the market to stress me out but what stresses me out the most is knowing traders are getting beat by the market and are losing every penny to the market for lack of proper risk and money management. I can empathize with the loss because I’ve been there myself. I know what it feels like. But, I know why I was in that situation.

So, I think we need to go back to basics. It’s very simple – traders that cannot control their emotions and cannot help themselves from overleveraging will never get out of the group of traders that lose 90% of the time.

Calculating Usable Margin:

The net bottom line on risk management is your usable margin percentage. Usable margin and usable margin percentage is your guiding light and is what you use to determine what trades you can make, how many trades you can make, and when you must stop trading.

Usable margin percentage is also what you use to determine when to cut a loss or when to hedge against negative entries. In order to even have a trading plan and a game plan to get yourself out of a bad situation it’s imperative you know what your usable margin percentage is at all times.

Usable margin can only run on a scale of 0% to 100%. Some brokers, especially MT4 brokers trick traders and deceive them with astronomical usable margin percentages like 3592%. Sorry, but you can’t have a usable margin percentage higher than 100% or lower than 0%.

No matter who your broker is, there’s only one way to calculate your usable margin percentage. The calculation is:

Usable margin divided by equity.

Example: your equity is $18,528 and your usable margin is $15,928 your usable margin is 85.96%. $15,928 divided by $18,528 equals 85.96%.

Usable margin in terms of liquid cash is determined by taking the amount of liquid you have in the market minus what your equity is.

Example: your equity is $15,000 and you have $550 in liquid cash usable margin live in the market. Your usable margin in terms of liquid cash is $14,450. Based on a liquid cash value of $14,450 your usable margin percentage is 96.33%.

Not to be rude, but if you cannot master these simple calculations and stay disciplined to always know what your usable margin situation is, you cannot trade the Forex market because in the end you will always lose and the market will always win.

Equity:

Equity is real simple – it’s the real-time true value of the account. For me account balance means absolutely nothing. I don’t even look at account balance because if I want to know what the real value of my account is at any given moment I need to look at equity.

Your equity does not reflect how much usable margin you have in the market. Reason being, if you get a margin call you still get your usable margin back. For example, if you have $1,000 in liquid cash in the market and you get an MC, you get your $1,000 worth of usable margin back.

Equity is the other number I keep a close eye on but not nearly as close as I watch my usable margin and usable margin percentage.

Calculating Entry Size:

Preventing yourself from getting into a margin call situation starts with making the proper entry sizes. If you don’t know how to calculate what a 0.5% used margin entry is you’ll never know when enough is enough and you’ll have no way of coming up with a game plan in case you go into “oh crap” mode.

Entry size is never based on account balance. I base entry size on the liquid cash value of my usable margin. Reason being, my broker determines a margin call based on what my usable margin is, not my account balance or my equity.

My broker requires me to maintain a usable margin percentage of 1% or higher at 100:1 leverage. At 200:1 leverage I’m required to maintain a usable margin percentage of 0.5%. You need to check with your broker to know what they require because not all brokers are the same.

Example: I have $20,000 in usable margin and I want to make a 0.5% entry. To determine how much margin comes out if I make a half percent entry I simply multiply my usable margin by 0.05 which is the mathematical equivalent to half of one percent. $20,000 X 0.05 = $100. At 200:1 leverage a $100 liquid used margin entry will pay me $2 per pip on the EUR/USD.

Now if it were me, I’d only be making 0.2% entries on an account of that size. So, in this case a 0.2% entry would take $40 liquid cash out of my usable margin and at 200:1 leverage will pay me $0.80 on the EUR/USD.

Usable margin, equity, and entry size are the holy trinity of risk management. These calculations are kindergarten simple yet neglected by the vast majority of retail FX traders. Almost no one teaches risk management. Brokers will teach traders how to use every crap tech indicator on the planet but they never teach them proper risk and money management. No shock there…

One of the so-called gurus was teaching to use 10% used margin entries per trade. This is insanity. In order to survive making those kinds of entries you literally have to pick the perfect tops and bottoms of the market. Your entries have to be flawless or you have to do the other thing they preach which is using 30 pip stoplosses.

The bottom line is, if you do what we say and stick to making 0.5% used margin entries and not allow your account to fall below 92% usable margin, it’s almost impossible for the market to move against you to such a degree that you’ll margin out.

Trading Multiple Pairs:

One of the other ways you can get in trouble is not knowing how to calculate your risk when you start trading multiple pairs on one account. I do not advocate this at all. If you want to trade multiple pairs, open up multiple accounts and trade each pair on a separate account.

I’m very much against trading multiple pairs on one account because it’s extremely difficult to know what your risk situation is at any given moment. For example, if you trade the EUR/USD and then you take a trade on the USD/JPY, and then the GBP/JPY, it’s going to throw off your numbers because you’re not making or losing the same pip value.

Not all pairs pay the same price per pip as the EUR/USD does. Suppose you have two EUR/USD trades in profit and you also have a trade on the AUD/USD in the negative, this too will complicate your ability to know what your risk situation is at all times. I think you can see where I’m going with this…

The more open trades you have on multiple pairs the more difficult you make risk management on yourself. To me it’s just not worth it.

Broker:

Part of proper risk and money management is trading through the right broker. If your broker doesn’t offer you the tools you need to manage risk according to your standards, this too will further complicate the issue.

For my trading style, I need a broker that will give me 200:1 leverage and the ability to take a trade on the same pair going both ways… if I have a euro long and I want to take a euro short, my broker has to allow this. I play both sides of the market. Plus, I have to have this ability in the event I need to hedge my account.

I also need my broker to allow me to take the opposite side for free. I call these free margin trades. If I have a euro long and the entry size for that long was $1000, I need my broker to allow me to take a euro short for $1000 and not have it take any usable margin out.

I also need my broker to show me what my usable margin percentage is on a scale of 0% to 100%. MT4 brokers are notorious for using a wacked out usable margin percentage number and this just confuses traders, it’s just a big scam to be honest.

There’s no perfect broker, they all suck in one way or the other, but I cannot trade unless my broker affords me those requirements.

That’s it. This is simple stuff. The calculations are simple. If you can’t grasp these basics, you can’t trade and the Forex market is going to eat you alive. There are times when you’ll find yourself in a situation where you have some negative entries and you need to formulate a game plan to get out of the situation. It’s a whole lot easier to think straight when you don’t have a low margin situation in addition to having negative entries to deal with.

If you have the 1+2 combo of low margin and negative entries, the market will first win the psychological battle and then will move on to win the war by cleaning you out. A trader can’t think straight and can’t have a clear mind if he is within 200 pips of a crap out before he decides to take measures to rectify the situation.