What is the risk in forex trading?
Risk in trading implies future uncertainty about deviation from expected earnings or expected outcome. Usually, the greatest risk for traders is uncontrolled loss of capital. High risk in the trading cause that around 95% of forex traders lose money.
Leverage in trading is a borrowed capital to increase the potential returns, and in the forex market, high leverage is up to 1:1000. So traders can trade with more money than they have.
Risk percentage = Risk / Capital
But there is the problem there – high risk in the trading cause that 95% of traders lose money. Traders need to know risk management trading forex rules.
Look at this table again and again:
As we know, if a trader risk and make a drawdown, he/she will need more percentage of money to recover. If you lose 50% of your equity, you need to earn 100% to recover.
The main reason why many traders don’t make money is not because of inexperience but from the poor risk management trading Forex. Due to the unpredictable nature of the Forex market, it is hazardous. Hence, Forex risk management is considered the success factor irrespective of whether you are a professional or a new trader.
In this article, you will get an insight into the top risk management strategies that will help you make profits and avoid a loss to have a good experience while trading Forex.
Practical risk management strategies in forex trading
In prop companies, traders will get Risk management rules, and for example, it looks like this:
1) Do not fall below X% relative drawdown. For example, 2% or 4%.
2) Do not fall below X% absolute drawdown. For example, absolute drawdown is the sum difference between the initial capital risk and a minimal point below that level, and many companies are set to be 5%.
3) Do not risk over X% on each trade. For example 1% per trade or 0.5% per trade etc.
4) Do not have more than 2% weekly drawdown. In that case, if some trader has above 2%, he/she will not trade that week anymore.
5) Position size needs to be calculated based on this formula.
Of course, rules can be more detailed; this is just an example.
Risk management strategies and related to position size calculation too.
Position size = Winrate – ( 1- Winrate / Risk Reward Ratio) is an example of the Kelly criterion (one of the simplest), but traders use their own formulas in many companies.
If you trade alone, you need to define your own rules and stick to those rules as a retail trader. If you lose more than wished in this day or week – stop trade and wait for next week. Do not chase for profit.
Risk management strategies in forex trading are:
- Have a proper understanding of the risks involved in trading Forex
- Make use of stop-loss in managing Forex risks.
- Never risk further if you can’t lose more.
- Limit the use of leverage in managing Forex risk
- Never have unrealistic profit expectations while managing risks.
- Manage Forex trading with take-profit
- Have a proper plan in Forex trading
- Always prepare for the worst.
- Expand your Forex portfolio
- Try to control your emotions.
If you are new to trading, the best thing you can do is educate yourself. Remember that your approach towards Forex trading should be similar to that of any career, in which you need to learn about the subject in detail.
However, there is a diverse range of resources such as Forex videos, webinars, and articles that can provide you with the absolute knowledge you seek. After gathering sufficient information on the various aspects of Forex trading, you can test yourself by opening a demo account.
The foreign exchange market and risk management is based on the trader’s plan when and how much lots he/she will trade.
In most articles on the internet for retail traders, the maximum recommended exposure is 2%, where traders risk no more than 2% of their available capital. In my prop company, the maximum risk is 0.5% per position and a maximum weekly drawdown of 2%. This is forex exposure management.
By using virtual funds, you can use the free account to trade Forex. Such type of account will help you to trade in the markets without any risks. As such, you will know the functioning of Forex markets, the different trading platforms, and various trading strategies.
#2: Make use of stop-loss in managing Forex risks
Typically, a stop-loss mechanism is a process of protecting the trades from unforeseen movements in the trading market. Simply put, it is a price that has been set earlier in the system at which the trade will close automatically.
Hence, a stop-loss is very important if you want your trade to end fine. You may consider setting the stop-loss at such a level where you won’t lose above 2% of the trading balance for a given trade. After you have set the loss margin, it is wise not to increase it.
That’s because there is no point in having a safety parameter if you won’t use it properly. Although there are certain types of these in Forex, determining your stop will rely on your experience. Moreover, analyze your stops frequently to find out if they were successful or not.
Of course, the traders do not like stop-loss because they can be “washed up.” It is a situation when the price hits your stop loss and then continues in your wished direction, and instead of profit, traders deal with a loss.
Because of that, a lot of traders use hourly close stop loss or daily close stop loss. For example, the trade will be closed if the daily close price is above or below some level.
Traders need to have some stop-loss anyway.
#3: Never risk further if you can’t lose more
This is considered one of the basic rules in the risk management of Forex trading. Unfortunately, this particular mistake is widespread in Forex traders who have just started. As the market is very unpredictable, traders putting in more money than they could afford are highly exposed to the Forex risks.
Recovering a Forex capital that has been lost is quite difficult because you need to make a greater amount to cover your loss. It is often seen that after a loss, many traders try to recover in the following trade. This is the worst thing to do because the account balance is low, and the risk increases. However, a tested rule is not to risk above 2% of the account balance a single trade.
For example, we have a trader who had $100 000 and traded 1 lot per time. After 500 trades, he has $50 000, and he still trades using 1 lot. This is a mistake. Less money, less position size. He should trade with 0.5 lots.
#4: Limit the use of leverage in managing Forex risk
In layman’s terms, leverage provides you with the chance to magnify the profits made out of your trading account. However, there is a possibility of a risk, and it increases. For instance, leverage on account of $400 of 1:200 generally means that a trade can be placed for about $80,000 (200 x $400). Similarly, when you apply a 1:500 leverage, you can trade for $200,000 (500 x $400).
Hence, by investing $400, you can experience a complete impact of $200,000 or $80,000. But the risks are quite high as you can have more profits if the market stands with you. Higher leverage can attract higher levels of risk. For beginners, it is suggested to avoid high leverage.
I like high leverage, but I do not want to risk more than I planned.
#5: Never have unrealistic profit expectations while managing risks
The main reason new traders are more aggressive lies in the fact that they have unrealistic expectations about earning profits. They harbor a false belief that only by aggressively trading will they earn more returns in a short time. Maintaining a conventional approach and realistic goals are the only way to get started in Forex trading.
When you are realistic, you can find out where you went wrong. It is crucial to exit when you realize that you haven’t made a good trade. Although it is natural to try in such a way to turn the worst situation into a good one, it is not the same with Forex trading and might end in disaster. Poor decisions in trading are often fueled by greed.
#6: Manage Forex trading with take-profit
When you are clear about your expectations, a simple way of securing profits is to use a take-profit. Just like the stop-loss, this works oppositely. A stop-loss automatically closes a trade to prevent further loss, whereas a take-profit automatically closes a trade as soon as it hits a specific profit level.
Based on each trade’s expectations, you will be able to set a specific profit margin and decide what should be the exact risk level for a particular trade. It is better to aim for a 2:1 ratio where the anticipated profit will be twice the trade risk.
#7: Have a proper plan in Forex trading
It is pretty common for new traders to make an entry to the platform and make trades relying on their instinct or following a piece of recent news. While some of them might lead to great trades, but in fact, they are the outcomes of sheer luck. For managing the risks involved in Forex trading, you will need to follow a plan that will outline a few important things.
These include opening a trade, closing it, fixing a stop-loss to take-profit ratio, percentage of balance you can afford to risk, and so on. Generate a plan and strictly adhere to it. A good plan will keep your personal emotions at bay so that you can’t over-trade.
The plan will bring discipline to your trading and help you in managing risks. Never ignore the rules or tend to bend them because every trade’s failure or success will depend upon it. A proven way of creating a great trading strategy is to follow and learn from experts in this area.
#8: Always prepare for the worst
As aforementioned, the Forex market is very unpredictable. Despite this, there is a lot of evidence in past events that show how a market reacts in a certain situation. Previous happenings or events might not get repeated, but it shows a trend.
Hence, it is crucial to consider the history of a particular currency pair that you are trading. Develop an action plan that will save you from a bad situation if that happens. It is unwise to underestimate the possibilities of sudden price movements. As such, you need a plan that will sail you through it.
#9: Expand your Forex portfolio
You may have heard about a popular risk management rule, which suggests never to put all the eggs in a single basket. Well, the same is true for Forex trading as well. When you have a wide range of investment, it will protect you in situations where the other market will compensate for the particular one that has been dropped.
With this frame of mind, you will manage the risk by ensuring that it’s a part of the portfolio and not everything. Another way of expanding your portfolio is to exchange a few currency pairs.
#10: Try to control your emotions
When you are trading in Forex, you should know how to control your emotions. Failing to keep a tab on the emotions won’t allow you to reach a suitable position to earn trading profits. That’s because emotional traders find it hard to adhere to the trading strategies and rules.
Stubborn traders will not exit despite losing streaks and expect to come out with shining colors after a few trades. But such a thing might never happen. A wise trader will withdraw after realizing the mistake with the smallest loss.
Once out, they will be patient and enter the market whenever an opportunity appears. A trader on a winning streak might become greedy and stop following the proper risk management strategies.
The best way for Forex trading works will vary from one trader to another and depend on their perspectives. Some traders will take calculated risks than others. It is recommended to start practicing in a conventional way of reducing the amount of risk. Do not chase for profit; wait for the opportunity, and think about risk every day.