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Back of the Envelope Trading Advice
What follows is strictly my own opinion and by no means should be taken as gospel by anyone, but it may help to serve a guideline for those contemplating trading FX.
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For the sake of argument assume that 1 pip = 1 basis point (1/100th of 1%)
1. How much should I risk on each trade?
If you are trading frequently ( 3 or more times each day) you should never risk more than 1% on each trade. What does that mean in real trading? If you are trading with 25 pip stops your leverage should not exceed 4X (25X4=100 pips =~1%) Why? Because the more you trade the more you lose. Just like a soldier who spends all of his time on the front line will likely get strafed by a stray bullet, so too if you expose your capital to the market on a day to day basis you will get hit by volatility.
Most traders focus on consecutive losers and then simply adjust their risk control from there, but that is a very deceiving metric. Losing in trading rarely happens by you making 10 stop outs in a row, but rather like this — win, loss, loss, win, loss, win, loss, loss, loss, win, win, loss, loss and so on until you’ve died a death of a thousand cuts. That is why keeping risk control at 1% is very important. The idea is to try to contain your drawdowns to no more than 25%-35% so that you can have a realistic chance of recovery. Remember, if you draw down 50% you need to make 100% just to get even.
If you are trading once a week or less you can risk up to 2.5% on a trade – so a 100 pip stop would mean that leverage should be no more than 2.5X
2. Are there ever any exemptions to these rules?
Generally no. But if you are trading a very. very high accuracy setup that is not too frequent and has tight stops then you can raise your lever factor to 10. For example I trade a strategy that is supposed to be 80% accurate using 25 pip stops. In this case I lever up 10X and risk 2.5% on a trade. That is MOST risk I will ever assume. (Note that is NOT the most risk I will suffer in real trading as gaps in pricing could turn a 25 pip loss into a 100 or 150 pip loss resulting in 10% or 15% loss on a trade. That is why you have to use such modest leverage in the first place. On any given day you can have your head blown off by unexpected volatility)
3. I hedge – can I ignore all your advice?
If you are non-US trader you can hedge your account by going both long and short the same pair which provides many traders with a dangerously false sense of security. Hedging is essentially volatility selling. You are basically betting on the currency pair bouncing up and down around some equilibrium level. So when it falls you cover your short position and when it rises you sell your longs. The problem happens when chop stops and trend begins. Once you’ve covered one leg of the trade you are essentially trading without a stop. So if the pair falls and you covered your shorts you are now long with no stop. Hello margin call.
The truly dangerous aspect of hedge trading is that it is like a disease that kills slowly. You can trade that way very successfully for a long time, but like all volatility selling strategies it only takes one market event to totally blow you up and I’ve never anyone who was smart enough to walk away from the table before their chips were lost.