Forex Risk Management - The 2% and 6% Rules.

About Forex Risk Management

Risk management is extremely important when trading in the foreign exchange currency market. In fact, a professional forex trader will not enter a trade under any circumstances until he or she calculates the risk of a trade first. In addition that trader will also calculate whether the amount of risk is acceptable. And what is an acceptable amount of risk? Well, when we do not have enough money in our trading account to cover the risk of a potential trade, we will not enter that trade. We will call that the permitted amount of risk. As in the example below, if we cannot afford losing 10 pips on this trade, we will not enter this trade under any circumstances.

On this chart the EUR/USD pair is trading at 1.3474
If we cannot afford to lose 10 pips, we do not enter a trade!

This is just an example. In a real-world scenario, it almost never makes sense to only risk 10 pips due to large volatility of the forex market. But how do we protect ourselves from losing that money? We use something that is called a protective stop. When we enter a trade, we are also allowed to place another trade in the opposite direction of the original trade. This means that if the market doesn't move in the favor of our trade, the second trade will be triggered. This action will exit out of the first trade with a loss. This amount of loss is the risk we are willing to take. We never enter a trade without placing a protective stop. There are absolutely no excuses for that. Before placing a trade, we should always define the location of our protective stop. Sometimes the currency pair reacts to news, or there is a large buyer. This sometimes will create a sudden movement in the direction that does not necessarily favor the choice we made when we placed a trade. These sudden, volatile movements are likely to wipe out an entire trading account's ballance in minutes, sometimes seconds. This doesn't happen all the time, but when it does happen it usually impossible to predict. We manage the probability of this event by always placing a protective stop on all trades we enter. We cannot ignore this rule if we want to be successful at trading highly volatile foreign exchange currency pairs.

The 2% Rule

What is the maximum amount of money we can risk in any position that we enter? One of the widely accepted risk management techniques is the 2% rule. As explained above, we never risk more money than we can afford to lose. And in addition, we never, under any circumstances, risk more than 2% of our trading account. This means that if we have $10,000 dollars in our account, we are only allowed to risk 2%, or $200. In many cases that equals 20 pips.

There is an important distinction that needs to be made here. The price per pip is defined by the currency pair you are trading and the position size you enter (calculated in lots, such as 1 lot, 2 lots, 10 lots, etc.) The amount of leverage your trading account has does not change the price per pip. It merely determines the maximum exposure you can have. That means that when the leverage is 100:1, you can hold positions in the market at approximately $100 for every $1 you have in your trading account depending on the currency pair being traded. A pip calculator is a tool that can be used to calculate the exact values for each currency pair.

To a beginner this may sound absurd because $10,000 sounds like a lot of money to have in a trading account only to be able to risk $200 (that is 20 pips, if you are buying 1 lot with a standard trading account). Remember that our goal is to develop a strategy that makes more money than the amount we are losing, no matter what those amounts are. Keep in mind that the larger our account grows, the more money we will be making by still following exactly the same strategy. Our goal is to grow the trading account incrementally. 2% of 10,000 is only $200, but 2% of 100,000 is $2,000. In either case, our strategy would not change. As we continue trading successfully, the amount calculated by 2% of the trading account would increase exponentially, and so would our profits.

The 6% Rule

The difference between the 6% and the 2% rule is that the 6% rule implies placing multiple trades at the same time as well as it works within a monthly time frame. The 2% and 6% may be combined. Let's take a look at how this happens. When we have multiple open positions working in the market at the same time, we never allow the amount of total risk be equal more than 6% of the trading account. For example, let's say that your account balance is $100,000 and you enter 3 trades simultaneously. Remember from the previous rule that we are only allowed to have up to 2% risk on each individual trade. This means that we are risking 6% of our account with these 3 trades. Now imagine a situation where one of these trades ends up losing money. We now have 4% permitted risk on the remaining 2 trades. While we did lose money on one of our trades, the other two are still on the loose, but at this point we are only allowed to risk 4% until the end of the month.

What to Do About the Losses?

There will always be losses. It is impossible to only make winning trades. This is something that an experienced trader has accepted long before he became successful. It is never our goal to only make winning trades. A losing trade that was taken off the charts by a protective stop is still a good trade - because not only were you able to successfully manage your risk in an uncertain situation, you only lost 2% of your account. This is not bad at all! Things could have been much worse.

But a professional trader already knows this and avoids losing large sums of money by implementing the 2% rule. Obviously, this is not to say that this is the only thing we need to think about when trading the forex market. But it is an important one. As enticing as it sounds to do otherwise, we cannot enter a trade if by doing so we are risking more than 2% of our trading account. Furthermore, we cannot risk more than 6% of our trading account when we enter multiple positions at the same time. By sticking to these rules, we are marginally increasing the rate of our success in the long run and stay ahead of the majority of traders.