Basics

Risk management terms: a glossary

The risk management terms are collected the way they are used in the calculations on this site: with a formula, a unit of measurement and a note about what the value is counted from. The base of the calculation matters more than the definition — most errors arise precisely because a percentage was taken from the wrong value.

Risk management: the main concepts of an account and a position

Balance: The amount on the account without open positions. It changes only at the moment a trade is closed, so it shows nothing while a position is open.
Equity: The balance plus the current result of open positions. It is from equity that the risk per trade and the drawdown are counted: this is the real state of the account right now.
Free margin: Equity minus used margin. The value by which the broker judges how close a margin call and a stop-out are.
Margin level: Equity ÷ used margin × 100 %. The figure the margin call and stop-out thresholds in the broker's specification are tied to.
Lot: A measure of size. A full lot on the currency market is one hundred thousand units of the base currency, a mini lot is 10,000, a micro lot 1,000. The minimum step is usually 0.01 lot.
Pip: The minimum standard change of a quote: 0.0001 for most pairs and 0.01 for yen pairs. The fifth digit of a quote is a fraction of a pip, not a pip.
Pip value: What one pip costs on a given size in the account currency. For a pair with the dollar second and a full lot it is $10; in other cases it depends on the rate.
Position notional: The size in units of the base currency: lots × contract size. It is from the notional that the required margin is counted, not from the risk amount.

Risk and loss

Risk per trade: The loss when the stop is hit, in money or as a percentage of equity. It is calculated before the entry: equity × the risk percentage.
R: A measure of risk at entry. The result of a trade in these units is tied neither to the size of the account: minus one R is an exit at the stop, plus two R a target twice as far.
Drawdown: The decline of equity from the previous maximum, as a percentage of that maximum. It is measured from the account maximum rather than from the first deposit.
Maximum drawdown: The deepest such decline over a period. The key risk characteristic of a system — unlike the return, it hardly improves over time.
The daily loss limit: The amount after which the trading day is over. It is usually a multiple of the risk per trade: a 3 % limit at 1 % risk is three stops.
Risk of ruin: The chance of reaching a boundary outlined in advance — say, minus half the account — at a known win rate, risk-to-reward ratio and risk share.
Margin call: A notification that the margin level has fallen to the broker's threshold. Not a closing of positions but a warning before it.
Stop-out: The situation where the broker closes positions itself: the margin level has fallen below its threshold. The closing price is the market one and does not depend on your levels.

The statistics of a system

Win rate: Winning trades divided by all closed ones. On its own, apart from the ratio, it says nothing about profitability — only together with the risk-to-reward ratio.
Risk-to-reward ratio (R/R): The distance to the target ÷ the distance to the stop. It is written as 1 : 2, where the two is the size of the target in units of risk.
Break-even win rate: The share of winners at which a system breaks even: 1 ÷ (1 + R/R). At a ratio of 1 : 2 that is 33.3 %.
Expectancy: The average result of a trade in R: win rate × R/R − (1 − win rate). A positive value is a necessary condition for a profitable system.
Profit factor: The sum of profits ÷ the sum of losses over a period. A value of 1.0 is break-even; below that the system loses.
Sharpe ratio: The return above the risk-free rate divided by the standard deviation of the return. A measure of the price in fluctuations at which the result was obtained.
Kelly criterion: The share of capital that maximises long-term logarithmic growth: (win rate × R/R − (1 − win rate)) ÷ R/R. In practice a fraction of it is used.
Exposure: The total size of open positions taking their interrelation into account. Three trades on correlated pairs are one large position rather than three independent ones.

Execution and costs on the currency market

Spread: The gap between the price at which an instrument can be bought and the one at which it can immediately be sold. It is paid at entry: a trade starts at a minus.
Swap: A charge or a credit for holding a trade across the boundary of trading days; its size comes from the difference between the two currencies' rates. Once a week the amount is tripled.
Slippage: The difference between the price in an order and the price at which it was actually filled. It appears in a fast market and on average plays against the position.
A gap: A break in quotes: the market opens far from the closing price. On a gap a stop triggers at the first available quote rather than at the one stated.
Stop-market: An ordinary stop-loss: when price touches the level a market order is sent. The close is almost guaranteed, the price is not.
A stop-limit: On a touch a limit order is placed. The price is guaranteed, the fill is not: in a fast move the position can stay open.

These six values explain most of the discrepancies between a calculation and the actual result of a trade. The first two are known in advance and go into the plan, the next two appear only at the moment of execution, and the last two are a matter of choosing the order type.

Frequently asked questions

How does equity differ from the balance and why does it matter?

The balance does not account for open positions, equity does. While a trade is open the balance does not change even if the loss already amounts to half the account. All risk and drawdown calculations on this site are made from equity — otherwise a drawdown would «appear» only at the moment trades are closed.

Are a pip and a point different things or synonyms?

They differ. The confusion arises with five-digit quotes: a change of the last digit is one tenth of a pip rather than a pip. Brokers call it a point, and the specification states it explicitly.

Why is the hole measured from the account maximum rather than from the amount deposited?

Because risk is measured relative to what you had rather than to what you started with. An account that doubled and came back to the starting amount is formally «at zero» relative to the deposit, but it lived through a 50 % drawdown — and it is that figure that characterises the system.

What is a lot and why does it equal 100,000?

A lot is the standard contract of the currency market: one hundred thousand units of the pair's base currency. A mini lot is ten times smaller, a micro lot a hundred. The smallest step at most venues is a hundredth of a lot, that is one micro lot.

How does the base currency differ from the quote currency?

In the pair EUR/USD the euro is the base currency and the dollar the quote currency. The quote shows how much of the quote currency one unit of the base costs. The pip value depends on this too: it is expressed in the quote currency.

What does «margin is locked» mean?

It is the part of the funds held by the broker for an open position. It is not lost, but it is unavailable for new trades and takes no part in absorbing a loss — that is exactly why the margin level matters rather than the account balance alone.

What is a swap-free account?

An account with no swap charged for holding a position overnight, usually offered as an Islamic one. The costs do not disappear: as a rule they are replaced by a fixed holding fee or a wider spread — the terms are in the specification.

What is slippage and is it always against the trader?

It is the difference between the order price and the fill price. It happens in both directions, but on average it works against the position: in moments of fast movement price goes exactly where the market was going.

How do major pairs, crosses and exotics differ?

Majors contain the dollar and trade with the narrowest spread. Crosses are pairs without the dollar; they have a wider spread and a different pip value. Exotics include the currencies of small economies: the spread there is several times larger and the moves are sharper.

What is ECN and how does such an account differ in costs?

On accounts with direct order routing the spread is usually narrower but a turnover commission is added. For the risk calculation that changes only one thing: the costs are counted as the spread plus the commission rather than as the spread alone.