Forex risk management is the cornerstone of profitability in the long run. Whenever you open a position, you expose your capital to a certain degree of risk. The main assignment of risk management is to minimize risk to the best possible extent. However, it is vital not to cut potential gains with very strict risk management strategy.
Beginner traders quite often overlook the rules of risk management, as they might care more about how much they get out of a single trade. This mistake frequently leads to tremendous losses, which is not something everyone can get through emotionally.
Therefore, we encourage you to read our complete Forex risk management guide to learn which tools and techniques can make your trading safer.
The first core principle of indicating Forex trading risk is selecting the position size that you can handle without worrying. One of the most common mistakes is thinking that trading big lots can make you rich instantly. The truth is that even advanced traders limit their position size to become less vulnerable to the Forex risk. Professionals lose trades as well, but they certainly know how to control the underlying risk and stay afloat. Knowing how much loss you can tolerate will give you a hint about a proper position sizing.
A golden money management rule in trading which says that the trader should not risk more than 2% of the capital per trade. We tend to think that for Forex novices this might be the best way to go. Such capital allocation limit can provide you with additional security. This is particularly useful if you have a losing streak, to give an example.
Leverage also plays its significant role in the size of the position. Leverage allows you to enter a large position with relatively low investment. Quite common leverage in currency trading market is 100:1, but can be higher. Selecting moderate leverage is crucial for solid trading risk management. Although leverage allows capitalizing on large positions, it magnifies potential losses as well. Newbies should never play with the leverage bigger than 100:1, as the lack of experience can negatively backfire on their capital.
There is a tool that can help you determine a position size in units and lots to measure the degree of your risk. It is called position size calculator and it is offered by various websites absolutely free of charge. Consider using it, as it is very useful.
Next significant aspect of managing Forex trading risk is determining your risk/reward ratio. We can infer from the name that risk/reward ratio presents the comparison of the anticipated returns to the amount of money the trader risks in case of loss. Optimal risk/reward ratio in Forex is key to playing safe and profitable. Most advanced traders stick to the optimal 1:3 risk/reward ratio. In fact, for beginners good risk-to-reward ratio can be even 1:2. It still might be unclear for some individuals how to understand this ratio, so let’s get straight to the practical example. For instance, imagine that you have a 1:3 risk/reward ratio. Generally, you accept the average loss of $100, but you make an average of $300 on your winning trades.
How basically can one manage risk/reward ratio? This is possible not only by defining the position size but with the help of stop-loss orders. Let’s discuss the importance of including stop-loss in your Forex trading risk strategies further.
Setting stop-loss is not just one of the optional Forex risk management measures, it is key for surviving in the currency trading market. To make the term clear, stop-loss is the order which triggers when the loss per one trade reaches the predefined price level. Stop-loss reflects the maximum loss you can afford. Likewise, the price level at which you set the stop loss must correspond to your risk/reward ratio and risk management strategy in general. Trading without stop-loss can result in massive losses, so it is definitely not worth it.
There are two types of stop-loss, i.e. non-guaranteed or standard and the guaranteed stop-loss order. Standard stop loss can secure your position, though under certain market circumstances it might not be triggered. This usually happens in times of very high liquidity in the market, when the broker might have serious problems with order processing and execution. On the contrary, guaranteed stop-loss will work regardless of the situation on the market. However, guaranteed stop-loss order are available only for an extra fee.
There are several ways to set stop-loss. You can set it manually, but it will unlikely be done with precision if you are just starting out. To place stop-loss properly, you have to utilize various tools, chart patterns and technical indicators. Let’s see some of them in our Forex risk management guide:
- Support and Resistance lines
- Fibonacci Levels
- Candlestick patterns
- Moving Averages
- Trend Lines
Trailing stop is also one of the handy Forex risk management tools. It is set as a percentage. Unlike fixed stop loss, the trailing stop secures profits by keeping the trade open and continues gathering profits just as long as the price of the currency pair is moving in the right direction. However, trailing stop will close the trade in case the price changes its direction by a previously defined percentage. The trailing stop used properly with the fixed stop-loss order can protect both investment capital and the gains.
A take-profit order is one of the main Forex order types that is designed to lock in profits. It is used by Forex traders everywhere and it is a mandatory part of Forex risk management strategies. How does it work exactly? Well, the take-profit order triggers when the price hits the specified rate or the number of pips. If this particular price level is reached, the trade will be closed and the profits will be collected. Indeed, this order will work only in case the rate moves in the right direction.
It is important to set the take-profit order in a realistic way. This means that the numbers of pips or the rate should be achievable at the point of entry. Likewise, the take-profit order should not be placed too close to the opening price, as you can cut your potential profits from the start.
Now let’s pass from the technical standpoint to the psychological side of things.
Trade duration and entry point
We also advise you to consider one of the most important Forex risk management tips. It says that you should not stay in trades for too long. Since Forex market is volatile, keeping the open position for an excessively long period can expose your capital to high risks. If you see that you have a losing trade, do not wait until you lose too much. Some traders wait for the miracle by hoping that the market will correct itself and that the losing trade will eventually turn into a winner. However, this does not usually happen. It is important to prevent emotions from overwhelming you, especially if it is greed that does not allow you to quit in time.
In addition, you should consider the time when you enter the market. The factor which is usually taken into account in this case is a volatility level. In fact, a high volatility represents the substantial amount of risk and it should not be overlooked when you choose Forex risk management strategies. If you see that the market is experiencing the high level of volatility, it is better to wait until the normal market conditions are back. There are several reasons for the high volatility. One of them is the expectation of the important market data release, such as non-farm payroll report. Therefore, we advise you enter the market when the trend is determined.
The points that we have just discussed lead to the conclusion that the trading must be disciplined. To ensure that emotions do not drive you, it is vital to stick to the well-designed trading plan. It is a crucial FX risk management technique.
The trading plan should include the trading instruments that you wish to focus on and the trading strategy you are going to use. Indeed, it is necessary to know about important news release highlighted in your economic calendar. Additionally, you have to decide how much trades you want to place per day. This will prevent you from overtrading which can significantly damage your capital. There is no need to place 20 trades in a row, as it is emotionally draining.
Thus, the trading plan is the great way to arrange every single step and protect yourself from the negative impact of the emotions.