Forex Risk Management: Getting to Know the Basics

One of the most discussed topics is, undoubtedly, Forex risk management. In terms of trading and forex, this is something that should on no account be ignored and neglected.

Understanding Forex Risk Management

The money-making business tends to be quite harsh. What’s more, it allows no mistakes. Even a single miscalculation might result in tremendous losses which may, in turn, force a business person to quit their venture. Therefore, to profit and make great money, you have to understand the concept of risk management. In other words, you’ll have to master managing risk and potential losses.

Absurdly, risk management falls into the most neglected areas when it comes to forex and trading in general. A great number of traders are simply eager to invest and immediately profit from trading. But what they fail is to consider their overall account size. They set the loss they could bear to lose and begin trading.

It’s no wonder why such a way of trading and investing is referred to as gambling. When you fail to incorporate risk management and its rules, you’re actually gambling. The thing is, you’re only expecting to win the jackpot; you’re not looking forward to obtaining a long-term and stable return on the investment you’ve made.

This is where the forex risk management rules kick in. Not only will they secure your investments, but they will also make them lucrative. Finally, forex trading is yet another numbers game. This implies that you must take advantage of every single factor and use it for your benefit.

What Exactly is Forex Risk Management

Forex risk management consists of particular actions that protect the traders against the trade drawbacks. Practically, more risk and higher investments mean a greater chance of considerable returns. However, they also mean the possibility of greater losses. Thus, the ability to manage the risk levels to reduce losses while boosting profit is the vital skill a trader should look forward to acquiring.

In brief, risk management involves defining both the proper position size and stop losses, as well as controlling your feelings and emotions while entering and exiting positions. If properly implemented, these strategies may become the key distinction between lucrative trading and bankruptcy.

Forex risk management

Forex Risk Management Fundamentals

It doesn’t take much to become a profitable and successful trader. One of the few essential things to incorporate in your forex trading is, without a doubt, risk management, as well as related strategies. To do so, you should grasp its five key components.

Risk Appetite

Developing your risk appetite is vital for adequate risk management. Traders should be aways ready to lose a specific amount of money, especially when it comes to some volatile currency pairs. This is particularly the case with certain emerging market currencies. Yet another factor that impacts risk management is liquidity in forex trading. Namely, less liquid currency pairs might make it difficult to enter and exit positions at the desired price.

In case you aren’t quite sure about the amount of money you should let yourself lose, you might set a too high position size. This will, in turn, result in considerable losses that might impact your capacity to invest in the upcoming trade, or something even worse.

Assuming that 50% of all your trades are winning, you could expect several consecutive losing trades. If you perform 10,000 trades, you will inevitably encounter 13 losses in a row. This fact highlights the significance of recognizing your risk appetite. You must pre well-prepared and have enough capital on your trading account for those occasions when bad luck strikes.
Regarding the money you should invest, it should amount to 1-3% of your overall capital per trade. Therefore, if you possess $100,000, your investment amount should be $1,000-$3,000.

Position Size

Choosing the adequate position size, i.e. the number of lots that you invest in trade is essential since the proper size will not only protect your trading account but will also boost your winning opportunities. To choose your own, you must calculate your pip cost together with lot size, define your risk percentage, and develop your stop placement.

Stop Loss

Stop-loss orders are placed to terminate a trade if a particular price is reached. This is yet another essential concept to grasp effective forex risk management. Being familiar in advance with the point at which to exit the position implies preventing possibly considerable losses. This point could be any point at which the trading idea is abolished.
A trader should incorporate stops and limits as well in order to accomplish a 1:1 (or higher) risk/reward ratio. This implies that you are investing $1 to possibly make $1. Place both a stop and a limit on every trade, but make sure the limit is equally distant from the temporary market price as the stop.

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Leverage

When it comes to Forex, leverage enables traders to obtain more exposure compared to what the trading account would allow. This further implies greater prospects to profit, but greater risk as well. Therefore, you should manage leverage cautiously.

The research has discovered that traders who had smaller capital in their trading accounts used significantly higher leverage compared to the traders with greater capital. But those who applied less leverage experienced much better outcomes than the traders with smaller capital whose leverage exceeded 20-to-1. Similarly, traders with huge capital who used 5-to1 leverage gained profit over 80% more frequently compared to traders with smaller capital who used 26-to-1 leverage.

To conclude, it is highly recommended that beginner traders should be cautious of applying leverage and the risks it incurs.

Emotion Control

Being able to control your emotions when investing money in any market is essential. Greed, enthusiasm, concern, or boredom may easily impact your decisions and thus expose you to excessive risk. Keeping a log or a forex trading journal may help you manage your emotions and trade soberly. Also, they could help you improve your trading strategies on the basis of previous data, leaving your feelings and emotions aside.

How Risk Management Works

To avoid blowing up your trading account, learning how to incorporate forex risk management rules and strategies is a must. What’s more, if you master them properly, you may not only earn huge profits but also become quite a successful trader. Risk management represents the capacity to control the losses to prevent you from losing all your capital. Generally speaking, it is a method that can be applied to everything that involves probability such as sports betting or gambling.

However an aggressive trader you might be, you should never make huge investments when it comes to forex trading. Even though the average risk of winning a reward may be 1:2 and that you may earn 50% of your investment, the outcomes of several upcoming trades might be devastating. For instance, if you invest 25% of your funds, it will take only four consecutive losses before you blow your account up.

On the other hand, if you decide to make small but smart investments amounting to only 1% of your funds, you may eventually make a profit of 4% in the upcoming eight trades. The final outcome will be as follows:
-1% – 1% – 1% – 1% + 2% + 2% + 2% + 2% = 4%

The bottom line is, never invest too much or, even worse, all your money per single trade. You certainly wouldn’t dare invest $5,000 out of $10,000 in only one trade, as it would take just two losses to end up with $0 on your trading account.

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Forex Trading “Holy Grail”

To incorporate risk management properly in your trading, you must get to know its key secret — position sizing. This is a method that determines the number of units to trade in order to gain the preferred risk level.

Before calculating your own position size, you must be familiar with three important things:

  1. Value per pip;
  2. The value of the currency you are investing in every trade;
  3. Your stop loss distance.

Value Per Pip

Value per pip represents the change of your profit and loss when the price changes by only 1 pip. To calculate it, you should consider three things: your trading account currency, the currency pair that is being traded, as well as the number of units.

Assuming that your trading account is in RSD, you trade in EUR/USD (the former being the base currency and the latter quote currency), and you long 100,000 units. If the traded currency pair increases by 1 pip, what impact would it make to your overall profit and loss?

To calculate this, the first step would be to define the value per pip of the traded currency pair. To do this, you should observe the quote currency (USD in this case). For 100,000 units of EUR/USD, the value per pip would amount to $10.

The second step includes defining the spot rate between the trading account currency (RSD) and the quote currency (USD). The third and final step is to multiply the spot rate by the value per pip of the traded currency.

The Value of the Currency You Are Investing

Basically, this refers to the amount you invest (and therefore risk) in every trade. When it comes to investments, you shouldn’t exceed 1% of your funds per each trade. The reason for this lies in the fact that you would want to avoid blowing your account up in just a few losses.
To calculate the currency risk per each trade, let us suppose that you possess $10,000 on your trading account. If you invest 1% of your funds in every trade, the outcome will be $100 (1% out of $10,000 amounts to $100). This further implies that you’ll end up losing no more than $100 per trade.
What you should bear in mind is the fact that the risk of bankruptcy is never linear. The more you lose, the more difficult it is to recover.

The Stop Loss Distance

Finally, what is left is setting your stop loss in terms of pips. There are multiple ways to do this. One of them is placing the stop loss at such a level at which, once attained, it will abolish the trading.

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Calculating Position Size

When it comes to forex, risk management, and position sizing are practically inseparable. It is impossible to incorporate risk management without adequate position sizing. To do this, you might want to use the following forex risk management — position size formula: Position size = Amount you are investing/(stop loss x value per pip)
If you are investing $100 (1% out of $10,00), the value per pip amounts to $10/pip (the value of a standard lot amounting to 100,000 units), and your stop-loss is 200 pips, your final result will be as follows:

Position size = 100 (200×10) = 0.05 lot (i.e. 5 micro lots).

In other words, if you trade 5 micro-lots on GBP/USD with 200 pips stop loss, your maximum loss would amount to $100 on this trade. This amount equals to 1% of your trading account.

Summary

Lucrative trading is the ultimate goal of all traders. A ranger of factors such as forex signals, major market events, specific strategies and techniques may affect the outcome of the trade. However, the key concept that none of the traders should ignore is forex risk management. To practice and incorporate it into their trade, traders should do the following:

  • Develop their risk appetite, consider their position side, risk/reward ratio, as well as the percentage of their capital for every trade;
  • Set stop losses to prevent the market from thwarting their position;
  • Be cautious with leverage and abstain from overusing it;
  • Control their emotions;
  • Keep a journal or log to make decisions based on genuine data.

If properly carried out and incorporated, these actions will secure your money and protect you from excessive risks and losses despite the high volatility of financial markets.