What Is the Importance of Risk Management in Forex Trading?

Risk management in forex trading is the most important thing you’ll ever learn as a trader!

 

 

Forex trading can be a roller coaster ride for unprepared traders. But, like any other form of investment, if you have strategies in place, you could even get to turn your forex dealing into a full-time career.

 

One major area any forex trader needs to find out about when they learn to trade is the significance of risk management.

 

Risk management in forex trading should be at the forefront of your trading strategy

 

Before thinking about how much you want to make from trading, you need to be thinking about protecting what you already have! 

 

If you lose it all, then you’ll never make your profit. You’ll have to quit and won’t get your break to trade again for a long time.

 

Risk management is a concept that has existed for a long time and is relevant to all kinds of trading and all kinds of business ventures. 

 

Every time you make a decision, you rake up the risks in your head; what are the likely outcomes and is the potential result worth it?

 

Learn how to trade forex

You will get to appreciate all the ins and outs of risk management in forex trading much quicker if you sign up for a comprehensive forex trading course, and our trading course will soon help you learn about dealing with different foreign currencies.

 

Forex trading can be a lot of fun for anyone making the effort to learn to trade, however, lots of people start trading and give up after experiencing one or two losses. 

 

One of the things you need to understand at the very start of your forex trading activities is that you are bound to have losses.

 

However, once you’ve mastered the art of trading, you’ll learn just how to mitigate your financial risks and begin to launch your own successful trading career

 

You can earn substantial sums of cash from successful forex trading and our useful guide to forex trading and how it works will give you a head start if you plan to start trading forex immediately.

 

This comprehensive guide explains all about currency pairs, forex spreads, and leverage, but doesn’t go into too much detail about risk management in forex trading. 

 

That’s the reason we’ve posted this article, to offer all our trainee forex traders bang up to the minute info on the management of risks in forex trading.

 

What is risk management in forex trading?

 

 

It’s recognised that up to 90% of new forex traders lose cash in their first few forex trades and many of them will give up trading at this point.

 

But forex is a massive global financial market and over $5 trillion is traded on exchanges on a daily basis. 

 

Traders can be active on the forex market 24 hours daily, and, what’s more, you don’t need to invest tonnes of cash into trading.

 

Plus, online forex broker commissions are competitive, making it easier to see profits from regular trades.

 

One of the most important learning curves for newbie forex traders is risk management, though.

 

Risk management in forex trading actually encompasses a lot of different aspects of forex trading, as we’ll find out in this article.

 

But the riskiest thing you could ever do is not have a plan in the first place! In such cases, you are basically gambling, which is the exact opposite of managing your risk. Having a trading plan is particularly important for exiting a trade.

 

Risk management in forex trading also involves abandoning strategies that no longer work. In the end, it’s all about reducing your exposure to risk in whatever form it may come.

 

And risk can even boil down to simple things like not signing up to an unregulated broker just because they offer a bonus.

 

Sure, in the short-term a sign-up bonus might be appealing, but in the long-term, you’ll be kicking yourself when you can’t get your money out!

 

By having a risk management strategy you can save yourself from greed. Never let it take control! Always remember to be patient, especially at the beginning.

 

Benefits of a proper risk management strategy in forex trading

Having a proper risk management strategy in forex trading can help you become a consistent trader and being consistent is tied to being successful in the world of forex trading.

 

In other words, not being consistent can be risky!

 

If you at the last minute decide not to follow your trading plan, you don’t know what to expect, and when you don’t know what’s coming you have a lot more to lose.

 

Plus, knowing how much to risk can make you feel more confident in your trades. 

 

You’re no longer thinking about what you could have gained, you now think about getting what you aim to get.

 

You can then rid yourself of any frustration at not reaching the highs other traders did or anxiety of not knowing what you want from the market.

 

The temptation of leverage

Leverage allows you to invest more cash into your forex currency trades, potentially offering greater profits by effectively borrowing from your broker. 

 

Leverage in forex trades can be as high as 1:1000, for example, meaning that for every £1 you invest into a trade your broker will add leverage of 1,000 x, so you can trade £1,000 worth of currency with your £1.  

 

Of course though, different brokers have their own rules on leverage and the current allowed limit by UK and EU regulators state that major forex currency pairs should only be allowed 1:30 leverage. While less popular currency pairings can be leveraged up to 1:20.

 

So, with that £1, you’re most likely only to be able to trade between £20 to £30. But still, it can offer a significant advantage.

 

And in the US, leverage can be as high as 1:50. There are even some brokers in some countries that allow up to 1:3000 leverage, which is pretty crazy!

 

However, applying leverage to your trades can be incredibly risky

 

If your chosen currency loses against the paired currency you will need to cover all losses made in the trade. Meaning, you will also need to pay your broker back for the money you borrowed, making your loss even greater.

 

But even if your trade is successful, you will still need to pay back your broker. So, even if you make a profit, your net profit will not exactly be what you get back from the trade. Brokers always get their cut of the deal!

 

That’s why it’s important to plan your forex risk management strategy in advance for all forex trades

 

But, of course, there are plenty of stories online of one-off traders who skip this vital detail and jump straight into trading and quickly develop what is referred to as ‘King Kong syndrome’.

 

These are people who have never traded before (and never bothered to learn about trading!) who opened a trading account with a few thousand dollars and lost it all in a couple of days.

 

Why does this usually happen? They trade far too much and use far too much leverage and lose it all!

 

They’ll make ridiculous trades that take up a third of their trading account, plus leverage to the max. A couple of trades later and they’re finished! It’s pretty sad.

 

If you do decide to use leverage, stick you 1:10. There’s no need to push it to the max until you are more experienced. And if you’re a new trader, we recommend that you stay away from leverage completely!

 

Diversify your risk

Diversification is also highly important to risk management in forex trading. Diversification is basically not putting all your eggs in one basket

 

For example, if you just trade the USD against the GBP, then you are especially susceptible to issues with that currency. 

 

If you trade several different currencies, you can avoid difficult situations and continue trading when your primary currency is down.

 

Risk-reward ratios

We all have a different appetite for risk. Without it, we would have no chance to make money. 

 

Low risk typically means low reward; don’t make the mistake in thinking there is ever a situation with low risk and high reward - that’s a dream. 

 

But it is something we can aim for, though a perfect situation will never appear.

 

What we are willing to risk for profit is referred to as our risk-reward ratio.

 

Paul Tudor Jones looks for a risk-reward ratio of 1:5. That means for every $1 he’s risking, he’s looking to get $5 back. If he can’t find such a situation, he won’t make the trade, it’s not worth his time. 

 

For him, it’s just too much risk, but for many though, a risk-reward ratio of 1:5 will be too high. 

 

Those opportunities are not always that common. Sure, when you’re rich like Tudor Jones, you can ignore plenty of opportunities, but most of us don’t have that luxury and have to take the risk.

 

For the majority of us, a risk-reward of 1:2 is more realistic. 1:1 is, in most situations, is not ideal, the amount you could get back isn’t very appealing. What’s the point of stressing over something so little?

 

Managing your risk in forex trading

 

 

As can be seen, managing risks in forex trading can be the difference between losing a fairly large sum on your first trade or regular profitability over a longer-term. 

 

When you manage forex trading risks effectively you will probably never be in the situation of losing all your cash.

 

Here are our top tips on effective risk management:

  • Monitoring position sizes: Work out what percentage of your funds will be used for any trade and stick to it. So, if you have a £10,000 trading account balance (including any leverage), you may want to limit your risk by 1% or 0.5% per trade. This means you would risk a loss of £100 or £50 per trade. The other risk factor to consider is your pip risk, meaning you need to set a stop-loss order at the most appropriate point.

 

  • Stop-losses: Placing a stop-loss order means the trade will close out after a specified total loss. You need to work out how many pips you are prepared to risk on any trade, ideally, this should be as close to your entry point as possible. You can find out more about pips in forex trading in our knowledge base. For many traders, placing a stop-loss is an absolute must.

 

  • Take profits: Another common mistake made by new forex traders is failing to recognise the point at which to take profits. There are strategies you can use to manage the point at which to take profits. Probably the best solution for newbie traders is to put a ‘close position order’ in place to take profits at the appropriate level of resistance. Candlestick recognition and moving average crossovers are some of the other strategies used by traders, and you can find out more on our site.

 

  • Having a trading plan: From all the above, you can see it’s vital to have a trading plan in place for forex deals. It’s important you don’t rush into trading and perhaps risk 10% of your capital on one trade, 20% on another and so on. Because this is the way to lose all your trading capital in just a few losing trades, and then you’ll have no option but to quit.

 

  • Staying disciplined: Put discipline in place with all your forex trades, this way you can build your capital slowly but surely. You may not make thousands in a couple of days, but equally, you won’t lose thousands either!

 

  • Keep a trading journal: A trading journal is the best way to learn what you’re doing wrong and what you’re doing right. As we mentioned earlier, risk management in forex trading is all about reducing any risks you might face. But unless you’re actively analysing your trades, you won’t be able to spot all the risks to your trading. A trading journal is the best way to do that.

 

  • Look for ‘confluence’: Confluence means where two points meet. In forex trading, what we mean by confluence is when two indicators are giving you positive signs to trade. The second acts as a kind of confirmation that there is a good opportunity ready for the taking. However, it’s worth mentioning what you see as a point of confluence, another trader may disagree; it’s entirely subjective.

 

All factors of risk management in forex trading

Our brief forex risk management guide above really just scratches the surface of risk management for forex trading. It’s a pretty hefty topic when you do a deep dive!

 

Once you’ve mastered the disciplines noted above, one other major risk management factor for all forex traders is to limit the use of leverage to levels that are more comfortable if losses are made. 

 

This way you’ll be sure to hold onto your trading capital for a longer period of time.

 

And, finally, risk management in forex trading is probably the most important lesson to learn. If you understand all the risks you face when forex trading, and plan your trades accordingly, you will have lots more trading fun!

 

Key points

If you remember anything from this article, make it these key points.

- Risk management in forex trading should be at the forefront of your forex trading strategy. Always think about preventing losses before making profits!

- Leverage is super risky. Sure, it may be a great way to trade with a lot more than you have, but your broker always gets paid, even when you lose!

- Diversifying your portfolio and knowing your risk-reward ratio is vital. Don’t put all your eggs in one basket and know how much you are willing to lose for certain opportunities.

- Without a forex risk management strategy in place, you’re basically gambling! You have no control over your risk, and it can become very easy to lose it all.


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Posted By jimbodean : 28 September, 2020
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If you lived in the United States before the year 2000, the thought of yellow and orange-jacketed traders screaming at the top of their lungs across a rainbow of other-colored jackets, slips of paper flying everywhere, is probably something you associate with markets and exchanges. These stressful environments were synonymous with the notion of markets. Emotions ran high, and depending on the exchange – one may even be risking their own personal safety by entering ‘the floor.’Times have changed quite a bit; many exchanges exist only in cyberspace, no longer seeing the need for physical manifestations of their trading activity. Even the New York Stock Exchange; have you seen it lately? If not, just turn on CNBC, it's not like it used to be (quite a bit more quiet these days).But one thing that hasn’t changed is the fact that people love fast markets. Only now they mostly exist through the Internet, and now they are available to anyone willing to risk their money – not only the select few that could afford or draw on family connections for a ‘seat on the floor.’   When a big news event happens; or even perhaps a news event driven by an economic catalyst, like the 2008 Financial Collapse, markets can attempt to price in the newest data so fast that prices move at breakneck speeds. For the poor investors that are in long positions in mutual funds, the hope of stemming the bleeding before market close doesn't exist. They have to wait and watch the devastation until the end of the trading day so that they redeem out of their mutual funds.But to the trader that can take a short position just as quickly as ‘hitting the bid,’ these ‘panic’ periods present quite a bit of opportunity. Prices are moving fast and pips can stack up quickly – if you are on the right side of the trade. The big question is if this is something that fits in your trading plan?What type of trader are you?By many accounts – fundamentals and news events create price changes, thereby – fundamentals dictate what prices will do. Technical analysis on the other hand, analyzes past price movements, showing us what prices have done. And sometimes, what price has done in the past can help us build a game plan for the future; looking to those fundamental catalysts to create big price movements (the hybrid fundamental-technical trader).The alternative approach is the trader that analyzes those same past events, looking to avoid those fundamental catalysts, hoping that the technical levels from the past hold true (the technical-range trader).That’s really all there is. A pure fundamentals trader wouldn’t be looking at charts at all, and a ‘technical-breakout/trend’ trader would really be, in many ways, looking to fundamentals to continue substantiation of those trending/breakout conditions, so they wouldn’t really be a ‘pure technical’ trader.Considering the fact that ‘panic’ markets can create rapid price movements in a short period of time, which can just as easily work against the trader as it can for them, it behooves one to know as much about their risk profile before wagering their hard-earned capital.So, if you consider yourself a ‘pure technical’ trader, and have no interest whatsoever in following or keeping up with the news – I advise you to attempt to avoid panic markets. This can often be done by setting stops at major levels of support (or resistance in the case of short positions) so that when we do get those big breakouts – they don’t work against you too heavily.For all those that dare to tread in fast markets – read on; and we will share with you some ways that experienced traders approach these volatile scenarios.How to Trade Fast MarketsThe same question was broached in the article ‘How to Trade Forex Majors Like the Euro during Active Hours,’ and the recommendation to trade breakout strategies could not be more on point.As David shows in the article, increased activity often means larger and potentially more erratic price movements. And because these movements can be more erratic, it can greatly affect the trader’s ability to forecast price changes. The chart below, taken from the aforementioned article, shows how widely price swings can magnify on EURUSD during the London and the London/US overlap session (often considered the most ‘active’ period in the FX market).   Now if we consider that panic markets often have an external stimuli; whether it be a natural disaster like what was seen in Japan in 2011, or a man-made disaster like what was seen at Bear Sterns and Lehman Brothers in 2008 – we have to know the market movements can be even more exaggerated, meaning price movements can become even more magnified, and forecasting can become even more difficult.Why trade breakouts to address panic?Because price movements can become greatly magnified while also becoming more erratic is the reason why trading breakouts is the best prescription for handling volatility. If we happen to be on the right side of the movement, price can trend for a continued period of time, giving us far greater potential profit targets if we are right. If we’re on the wrong side of the movement (which will probably happen more than half of the time), then we can cut our losses early before the pair continues against us in a move that could potentially drain our accounts.A critical aspect of trading breakouts is the necessity of strong risk-reward ratios, such as the trader risking 20 pips, but looking for 100 pips if correct. This could be expressed as a 1-to-5 risk-to-reward ratio (20 pips to the stop-loss order – 100 pips to the profit target = 1:5 risk-to-reward).This is what can allow rampant volatility to actually work in your favor.With a risk-reward ratio so aggressively on the trader’s side, one would need to be right only 2 out of 5 times to gleam a net profit. If a trader was right 40% of the time with a 1-to-5 risk-to-reward ratio, they could be looking at a handsome profit (2 winning trades at 100 pips each = 200 pips won, 3 losing trades at 20 pips each = 60 pips lost, net profit of 140 pips (200-60) not including commissions, slippage, etc).But what if the trader above was only right on one out of five trades? Well, they are still looking at a net profit (once again, not including spreads, slippage, etc). One winning trade at 100 pips only gives up 80 to 4 losers at 20 pips each, leaving a net profit of 20 pips; and that is with a winning ratio of 20%.How to Trade BreakoutsAn easy way of looking at breakout strategies is to simply think of ranges – and then reverse it.While range-traders look to buy support and sell resistance, breakout traders await breaks of resistance to buy (in anticipation of price continuing to rise now that resistance is broken) and looking to sell when support is breached (once again, looking for price to continue heading lower).There are numerous ways of identifying support and resistance levels to be used for breakout strategies. Some traders don’t even use indicators, electing, instead, to simply analyze and build their strategies off of price, and price action. Some traders rather use strategies based on indicators like Price Channels to point out these support and resistance levels. Many of the various Pivot Point offerings or Fibonacci studies can help in this same regard as well.Whatever the mechanism, it is important to realize that complete elimination of false breakouts is totally impossible. What often makes or breaks a breakout strategy is money, risk, and trade management.This is a hazard sport, as it can be a regular occurrence for price to break support (or resistance) briefly enough to trigger our, only to pop back into its prior range. This can be frustrating for breakout traders, and has even earned the title of the ‘false breakout.’This topic was explored in greater detail by Walker England in the article ‘Can False Breakouts be Prevented?’Not to spoil the article, which you should absolutely read, but the answer to the question is ‘No.’ False breakouts, unfortunately, cannot be prevented.To the trader looking to be more conservative, additional ‘wiggle room’ can be given to the entry in an effort to attempt to decrease the chances of caught by a false breakout.But preventing false breakouts is impossible due to the simple fact that no trader in the world knows what will happen next. So when trading panic markets, protect your trade, protect your account, and trade your plan.


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