A lot of the common literature on what to risk per trade often centers around a defined percentage, typically 1, 2,3, or even 5. Ultimately, this metric is the only thing within a trader’s control and is the foundation of position sizing and money management overall.
On the surface, this fixed percentage model seems logical. Yet, it misses one key component, and that is the trade frequency. Also, many other factors are worth scrutinizing, like experience, skill, net worth, and overall risk tolerance.
So, this article will provide examples of how the risk varies drastically from one trading style to another and introduce a more sensible and better approach.
An example of two different trading frequencies
So, let’s imagine a day trader (A) and a swing trader (B) were both starting with a $5000 balance. Trader A decides to put down 2% per order, effectively $100. However, if they have not accounted for how often they execute, this figure could be too high.
Let’s assume they do five positions daily on average. At 2% each, this amounts to 10% or $500 every day, which is relatively high by any standards. It should be clear that while 2% sounds reasonable, it doesn’t paint the full picture.
Now let’s look at Trader B. So, let’s presume the swing trader also allocates the same 2%. If they only execute once a week, in 5 weeks, that is 10%. Potentially losing 10% over this period due to a losing streak is a lot better than in one day.
The higher one’s engagement is, the more volatility one needs to withstand. In such an environment, too much risk can quickly shrink a trader’s equity. So, although it might seem both groups are risking the same, this does not account for the execution incidence.
Introducing the risk per unit of time model
Now that we’ve established the main drawback of the fixed percentage model, we should consider something better. A more risk-conscious approach is to weigh the risk per unit of time. So, what does this mean?
It’s merely a method to define absolute risk over a longer period than only thinking of risk for every individual position. For instance, one would need to determine what they’re prepared to stomach over weeks if they’re a day trader, months if they’re a swing trader, etc.
Knowing this point assumes someone knows their historical maximum drawdown, which becomes a reference point for where they should go below. Referring back to trader A, they might define their maximum weekly risk on a $5000 account as $500.
After that, they can work backward to determine the actual per-trade allocation.
If the trader executes five times daily, they will divide the $500 by 25 (5 X 5), resulting in $20.
Let’s refer back to trader B. Due to their long time horizon, they might instead determine their threshold over two months. They may also not want to go over $500 or 10% of the $5000 equity. Therefore, if they averaged one position a week, they’d be risking $62.5 (500 divided by eight weeks/two months).
Trading frequency isn’t correlated with maximum return
There is something else worth noting on the relationship between how often someone trades and their per-trade risk. Some might be under the impression the more they execute, the bigger the returns.
However, this perception is fundamentally flawed for a few reasons. Speculators who regularly execute almost always will have much smaller profit targets since their holding times are much shorter, whether within a day or a few hours.
This factor is another aspect of thoroughly being comfortable with the real per-risk amount in relation to how many positions will occur over a given period. So, while someone holding their trade for a few hours could gain tremendously in that one moment, this comes at the danger of too much monetary risk.
When traders allocate above what they’re comfortable with, they typically employ a tight stop.
This means they are far more likely to be kicked out just from the natural fluctuations occurring in an hourly or 4-hourly volatility range.
These are some of the disadvantages a more active trader must mitigate, primarily by adequately accounting for the per-trade risk and keeping it consistent.
Monetary risk is more important than a defined percentage
Many traders place too much significance on a defined percentage and less on a monetary value they are comfortable with. Some literature suggests by doing this, someone doesn’t feel any emotional attachment to their losses, but this, again, is quite erroneous.
More specifically, forex is the highest leveraged instrument, meaning we don’t need to keep all our risk capital in an account. In reality, the money in someone’s equity is just a margin to maintain all the positions they’ve taken.
Whether they technically risk 1% or 10% is irrelevant. What matters more is being comfortable and responsible for the dollar or currency equivalent amount on the line, whether that is 10, 100, or 1000.
As traders, we must consider the true risk being taken in the markets by thoroughly assessing the worst-case scenario and thinking days or weeks ahead. One of the detrimental mistakes for losing is risking too much.
The damage is accelerated further when one doesn’t plan in advance how often they should engage with trading. Money management is no cookie-cutter approach and is going to be quite personal from one trader to another depending on their trade frequency, strategy, and maximum risk tolerance.