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What is Forex Risk Management? Learn the Basics

What is Forex Risk Management? Learn the Basics

2019-08-22 15:24:00
Ben Lobel, Markets Writer
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Effective forex risk management allows currency traders to minimize losses that occur as a result of exchange rate fluctuations. Consequently, having a proper forex risk management plan in place can make for safer, more controlled and less stressful currency trading. In this piece, we cover the fundamentals of fx risk management and how best to incorporate them into your process.

What is forex risk management?

Forex risk management comprises individual actions that allow traders to protect against the downside of a trade. More risk means higher chance of sizeable returns – but also a greater chance of significant losses. Therefore, being able to manage the levels of risk to minimize loss, while maximizing gains, is a key skill for any trader to have.

How does a trader do this? Risk management can include establishing the correct position size, setting stop losses, and controlling emotions when entering and exiting positions. Implemented well, these measures can prove to be the difference between profitable trading and losing it all.

Top 5 Fundamentals of Forex Risk Management

1. Appetite for Risk

Working out your appetite for risk is central to proper forex risk management. Traders should ask: How much am I willing to lose in a single trade? This is particularly important for the most volatile currency pairs, such as certain emerging market currencies. Also, liquidity in forex trading is a factor that affects risk management, as less liquid currency pairs may mean it is harder to enter and exit positions at the price you want.

If you don’t know how much you are comfortable with losing, your position size may end up too high, resulting in losses that may affect your ability to take on the next trade – or worse.

Let’s say 50% of your trades are winners. In the long term, mathematically you can expect to have runs of multiple losing trades in a row. Over a trading career of 10,000 trades, the odds suggest that you will face 13 sequential losses at some point. This underlines the importance of knowing your appetite for risk, as you need to be prepared, with sufficient money on your account, for when bad runs hit.

So how much should you risk? A good rule of thumb is to only risk between 1 and 3% of your account balance per trade. So, for example, if you have an account of $100,000, your risk amount would be $1,000-$3,000.

2. Position Size

Selecting the right position size, or the number of lots you take on a trade, is important as the right size will both protect your account and maximize opportunities. To select your position size, you need to work out your stop placement, determine your risk percentage and evaluate your pip cost and lot size. For more on how to do these things, click on the link above.

3. Stop Losses

Using stop loss orders – which are placed to close a trade when a specific price is reached – is another key concept to understand for effective risk management in forex trading. Knowing the point in advance at which you want to exit a position means you can prevent potentially significant losses. But where is this point? Broadly, it’s whatever point your initial trading idea is invalidated. For more detail on this concept, click on the ‘Using stop loss orders’ link above.

How to use a stop loss order for managing trading risk

Traders should use stops and also limits to enforce a risk/reward ratio of 1:1 or higher. For 1:1, this means you are risking $1 to potentially make $1. Place a stop and a limit on each trade, ensuring that the limit is at least as far away from current market price as your stop.

The table shows how the outcomes of different risk-reward ratios can change a strategy:

Risk-Reward

1-1

1-2

Total Trades

10

10

Total Wins (40%)

4

4

Profit Target

100 pips

200 pips

Stop Loss

100 pips

100 pips

Pips Won

400 pips

800 pips

Pips Lost

600 pips

400 pips

Net Gain

(-200 pips)

200 pips

As can be seen in the table, if the trader was only looking for one dollar in reward for every one dollar risked, the strategy would have lost 200 pips. But by adjusting this to a 1-to-2 risk-to-reward ratio, the trader tilts the odds back in their favor (even if only being right 40% of the time). For a full breakdown of this concept, read more on risk reward ratios for forex.

4. Leverage

Leverage in forex allows traders to gain more exposure than their trading account might otherwise allow, meaning higher potential to profit, but also higher risk. Leverage should, therefore, be managed carefully.

While researching how traders fared based on the amount of trading capital being used, DailyFX Senior Strategist Jeremy Wagner found that traders with smaller balances in their accounts, in general, carried much higher leverage than traders with larger balances. However, the traders using less leverage saw far better results than the smaller-balance traders using levels over 20-to-1. Larger-balance traders (using average leverage of 5-to-1) were profitable over 80% more often than smaller-balance traders (using average leverage of 26-to-1).

Based on this information, at least when starting out, it’s advisable for traders to be very wary of using leverage and to be mindful of the risks it poses.

5. Controlling Your Emotions

It’s important to be able to manage the emotions of trading when risking your money in any financial market. Letting excitement, greed, fear or boredom affect your decisions may expose you to undue risk. To help you take your emotions out of the equation and trade objectively, maintaining a forex trading journal or log can help you refine your strategies based on prior data – and not on your feelings.

Forex risk management: A case study

DailyFX analyst Nick Cawley explains a trade he made on EUR/USD, demonstrating the processes that go into sound forex risk management.

DailyFX analyst Nick Cawley

“I opened a long position on EUR/USD at 1.1100 with a 1:3 risk/reward ratio and a position size of £5 per pip, representing just 3% of my account balance. This was an attractive trade on the charts and meant I stood to profit £300 if the target was met.

To protect against losses I set a stop loss at 20 pips away, as below this mark I wouldn’t have felt comfortable with the trade. I chose the leverage of 1:1. Doing all of these things and recording the trade in a journal meant I could minimize emotions and manage risk in the most effective way possible”

Forex risk management: Top takeaways

In summary, to practice solid forex risk management, traders should:

  • Work out their attitude to risk, thinking about risk/reward ratio, position size, and percentage of account balance for each trade
  • Place stop losses to protect against the market going against their position
  • Be wary of leverage and using too much
  • Keep a handle on emotions
  • Use a journal to make decisions based on existing data rather than personal feelings.

Further reading on forex trading

For more information on getting started in forex trading, download our New To Forex trading guide, the perfect introduction to the world’s biggest financial market. Traders of all levels can also learn what our DailyFX experts are trading in our Analyst Picks section.

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