Luka
Feb 24, 2025
Blogs
Trading financial markets can be both exhilarating and daunting. The potential for significant profits is often what draws people in, but the reality is that trading is inherently risky. Without proper risk management, even the most skilled traders can find themselves wiped out. Risk management is not just a tool; it’s a survival mechanism. Beyond capital preservation, risk management is crucial for maintaining mental clarity. Large drawdowns have a psychological impact that often leads to poor decision-making, revenge trading, and emotional trading mistakes. The larger the drawdown, the harder it is to recover. This is due to the exponential nature of percentage gains required to break even after a loss. For example: A 10% loss requires 11.1% gain to get back to the initial capital A 30% loss requires 43% gain to get back to the initial capital A 50% loss requires 100% gain to get back to the initial capital This exponential relationship means that the deeper the drawdown, the harder it becomes to recover. Therefore, preserving capital is not just about avoiding losses; it’s about ensuring that you can continue trading effectively without being forced to take excessive risks to recover from significant drawdowns.
Calculating risk properly
A structured approach to risk calculation ensures that every trade has a predefined level of risk relative to the total equity, but different asset classes require different calculations.
Let’s break down position size calculation for different instruments:
We will assume an equity of 100000$ and 1% risk per trade.
Forex pairs
Let's take the example of trading EUR/USD pair, with 20 pip stop loss.
To determine the pip value for specific forex pair, you can use free online pip value calculators. For easier calculation, let's assume the current pip value for EUR/USD is 10$.
Futures
Let's take the example of trading E-mini S&P 500 futures, with 20 tick stop loss.
To find the tick value for speficic asset, you can visit the futures broker websites – for example the AMP futures contact specifications.
Cryptocurrency
Let's take the example of trading Bitcoin with 200$ stop loss.
To make calculations faster and easier, you can use the online calculators, such as :
Upgrading the fixed % risk per trade model
The industry standard for risk management is to risk a fixed percentage of your equity per trade, typically 1% or 2%. While this approach is simple and effective, it may not always be optimal. Let’s explore a more dynamic approach that adjusts risk based on recent performance.
Start with 1% risk per trade
Post a winning trade, increase risk by 0.5%, until maximum 3% risk per trade is reached
Post a losing trade, reduce risk to 0.5% per trade
If you lose the trade on 0.5% risk, further reduce the risk to 0.25% and keep that risk % until you win a trade, then return back to 0.5% and continue with increasing risk by 0.5% post a each winning trade
Let's look at the sample of 10 trades, comparing fixed 1% risk model against the dynamic risk model. Below is a 10 trade sample with a reward to risk ratio of 2:1.
Trade # | Fixed 1% Risk | Equity (Fixed) | Dynamic Risk | Equity (Dynamic) |
1 (Win) | +$200 [1% risk] | $10,200 | +$200 [1% risk] | $10,200 |
2 (Win) | +$204 [1% risk] | $10,404 | +$306 [1.5% risk] | $10,506 |
3 (Win) | +$208 [1% risk] | $10,612 | +$420 [2% risk] | $10,926 |
4 (Loss) | -$106 [1% risk] | $10,506 | -$273 [2.5% risk] | $10,653 |
5 (Loss) | -$105 [1% risk] | $10,401 | -$54 [0.5% risk] | $10,599 |
6 (Loss) | -$104 [1% risk] | $10,297 | -$27 [0.25% risk] | $10,572 |
7 (Loss) | -$103 [1% risk] | $10,194 | -$27 [0.25% risk] | $10,545 |
8 (Loss) | -$102 [1% risk] | $10,092 | -$27 [0.25% risk] | $10,518 |
9 (Win) | +$202 [1% risk] | $10,294 | +$54 [0.25% risk] | $10,572 |
10 (Win) | +$206 [1% risk] | $10,500 | +$108 [0.5% risk] | $10,680 |
Total P&L | +$500 | $10,500 | +$680 | $10,680 |
The difference? The first thing that stands out is the higher equity in the dynamic risk model. However, this is not the main point to focus on here. We have learned that the true problem with losses is the percentage of drawdown formed from the equity high since the percentage return needed to recover grows exponentially with larger losses.
We can see that the equity high is reached after trade #3, followed by five losing trades, which create the drawdown we are going to analyze.
Equity | Fixed 1% Risk | Dynamic Risk |
Equity high | $10,612 | $10,926 |
Equity low | $10,092 | $10,518 |
% draw down | 4.9 % | 3.7 % |
With the difference in drawdown, to return to the equity high using the fixed 1% risk model, we need to generate a 5.2% gain to cover the 4.9% drawdown. In the case of the dynamic risk model, a 3.8% gain is required to cover the 3.7% drawdown.
The path to sustainable trading
Risk management is the cornerstone of successful trading. It ensures that you can survive the inevitable losing streaks and thrive during winning ones. By understanding the exponential nature of losses, calculating risk accurately, and adopting a dynamic approach to risk management, you can significantly improve your chances of long-term success.
In future blogs, we’ll dive deeper into advanced risk management techniques, such as the Optimal F and the Kelly Criterion, which can help you optimize your position sizing further. Until then, remember that trading is a marathon, not a sprint, and proper risk management is your best ally in this journey. Stay disciplined, stay informed, and always prioritize protecting your capital.
