Forex loss limitation

Forex loss limitation

Losses are as inevitable in active trading as operating costs in a company. Losses only ruin traders when they get too big. Therefore, an effective and consistent limitation of losses is the (most important) key for long-term success in the markets.

When opening a position, it must therefore be determined what the maximum loss will be if the market does not develop as expected. This is implemented by means of a stop loss, which automatically closes a deficit position when the pain limit set by the trader is reached.

In the relevant literature, there are no uniform recommendations for the amount of the maximum loss that traders with a position should risk. A loss of up to 1 percent of the account balance can be classified as sensible.

It goes without saying that the leverage that is practically always used in forex trading must be taken into account when determining position size. The difference between the entry price and the stop loss, measured in pips, multiplied by the pip value of the position, must not exceed the specified maximum loss amount.

Explore the individual pain threshold

Explore the individual pain threshold

The optimal value for the maximum loss per position depends on different sizes. On the one hand, the trading system plays an important role. On the other hand, a psychological component must also be taken into account. The maximum loss per position should not be so great that it is painful. In practice, painful losses or the fear of their realization all too often lead to irrational decisions, such as deactivating a stop loss order.

Professional risk management goes beyond determining a maximum loss per position. Traders must also pay attention to whether they are invested in different positions that have a high correlation with each other. In practice, for example, the US dollar and gold often have a high correlation (the correlation coefficient is close to +1 in the short observation period). If the market develops in a certain direction, a loss can be expected in both positions. You correlate the positions of the trading account highly, the maximum loss per position should be set lower.

Time factor: pull the emergency brake when there are high losses

In many professionally managed portfolios, risk management is extended by a time component. In addition to the maximum loss per position, a value is set for the loss that is accepted per day, week and month. If the account reaches the specified loss limit in one of these intervals, all positions are closed up to the following interval. Some approaches are also limited to closing loss positions.

Consistent risk management is tedious, but essential. This can be illustrated by the so-called recovery effect: If a trading account loses 50 percent of its value, it must double afterwards in order to return to the initial value. If the loss is limited to 10 percent, only a good 11 percent profit is then required to restore the initial situation.