Risk management is a broad term. It encompasses every aspect of FX trading from the initial risk-assessment phase, leverage, the entry and exit strategies, and finally, the amount of capital or money you are willing to risk on any one trade.
A successful trader will pay attention to each of these areas in their trading plan and ensure that they are in line with their overall trading goals and objectives. If traders cannot control risk, they will not be able to achieve long-term success, regardless of analysis or execution. Risk management in forex trading is also an ongoing process; it is a constant aspect of trading that needs to be monitored and evaluated daily. It isn’t something you can just do once and then forget about; it must be assessed continually while you are trading to minimize your losses. What follows are some practical steps that you can take as a trader to manage your risk more effectively:
1. Trade with positive expectancy
Trading with positive expectancy is a crucial concept every trader should know. A positive expectancy means that a trading strategy, over time, will produce more winning trades than losing trades and produce larger winning trades than losing trades. It means that the system you are using is profitable.
If the expectancy of your trading system is positive, the odds are in your favour. It doesn’t mean you can’t have several losing trades in a row or even a significant drawdown. It does mean that over time you can expect to be profitable. Positive expectancy can also be defined as the amount you can expect to make per dollar at risk on every trade.
2. Use stops (Normal stops, trailing stops, and limit orders)
Traders can use stop-losses to close losing trades automatically at predetermined levels to limit potential losses. One of the mistakes traders make is avoiding taking losses by not placing stops, but this only increases their losses when they eventually get stopped out on a significant loss. This negative experience reinforces their belief that stops don’t work, so they stop using them altogether.
Another mistake traders make is placing tight stops close to the current market price. These types of stops can be triggered by market volatility, causing a trader to exit a trade prematurely.
A good rule of thumb is that the protective stop should be placed outside the average volatility of the instrument you’re trading. For example, if you’re placing a long position in USD/JPY, you could put your protective stop below the low of the last ten candles — this will give you a fairly wide stop, and it will also take into account short-term volatility spikes.
The fact is that once an order reaches a certain level, it becomes an order and no longer an opinion. The idea behind an entry and exit order is based on statistics and risk management — there’s nothing personal about it. It’s all about managing your risk effectively and limiting your downside while giving yourself plenty of room.
3. Determine the risk-reward ratio
Forex risk management is about knowing exactly how much you are willing to lose on any trade. It is essential to know this number before you enter a trade because it allows you to determine the number of lots (or contracts) that you will be trading.
The first thing we need to do is determine the risk-reward ratio for the trade. The risk-reward ratio is how many pips we can expect to lose versus how many pips we can expect to gain from a transaction. For example, if our stop loss was 50 pips away from our entry point and our take profit was 100 pips away, our risk-reward ratio would be 1:2. If we risked 50 pips, our reward could be 100 pips.
It’s important to note that the actual potential gains are not guaranteed; they are only estimates based on factors such as past performance or technical analysis (charting). What you can be sure of is what your maximum loss could be if the market moves against you. The goal of trading with a positive risk reward ratio ensures that you generate more profits than losses by making profitable trades more frequently than unprofitable ones.
4. Diversify across markets
Most investors are familiar with the concept of diversification. However, they probably don’t know that they can still be at risk even if they’re holding various stocks or funds in their portfolios. That’s because the securities could be highly correlated — meaning that when one goes up, the other goes up as well.
And if that happens in a bear market, you could have too much exposure and lose money. For example, the EUR/USD and GBP/USD currency pairs tend to move in the same direction. Diversifying your portfolio means you hold assets that have low correlation factors.
You can use SMA (simple moving averages) to measure if two markets are correlated. For example, if two markets have a 90 period SMA that moves similarly over time, their charts will probably be correlated. If you find some markets with little or no correlation with each other, you might consider trading them simultaneously to reduce risk. Look for similar price action setups across multiple time frames in the forex market.
5 – Position sizing
Position size refers to the amount of money you put on each trade relative to your account size. Many traders put too much money on each open position, which puts them at a high risk of ruin because it only takes a few consecutive losses to run out of money. It would be best to use position sizing to limit your risk and continue trading even after a few straight losses. The 1% rule is a fundamental risk management concept that all traders should follow. It simply states that risk (loss) on any trade should not exceed 1% of your account equity. For example, if you have a £10,000 trading account, the maximum loss on any single trade should be £100. This means you can lose ten trades in a row and still have some trading capital.
Final Thoughts
Risk management in forex trading is always beneficial, but this lesson is vital for an experienced trader. There’s a difference between taking a risky trade and throwing money at trades, hoping they turn into something. As a professional forex trader, you must understand the currency market and the risks involved with the positions you take. If significant losses occur too frequently, it could be time to rethink your strategy and risk management plan
To learn more about forex trading, visit our education section. To find out more about our recommended forex brokers, check out our forex broker reviews.
