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Forex trading entails market risk. But don’t fret; risk doesn’t always result in losses – unless you fail to manage it properly.
Risk management techniques are tools you must master to protect your trading capital and play along with the market risks. In this lesson, you’ll learn the importance of risk management when trading the forex market.
Risk management is something you’ll come across tons of times when you’re studying forex trading. It applies to any financial endeavor you might take, like investing, running a business, or loaning.
Why? Because the financial market is filled with risk. The moment you enter it, you’ll face various risks that can impact your trading activities and investment capital.
But with risk management, you’ll have a sound trading plan that shields you from potential losses due to risk. Also, having risk management techniques ensures that you’re up for profitable opportunities in the long run.
Sounds great, right?
Sadly, many new traders overlook risk management because they’re looking for that “jackpot” and not the long-term return. Which makes them what? A gambler trader. I’m sure you don’t want that.
You can use several risk management techniques to battle the risky scene of online trading. While no definite technique ensures your desired result, there are proven strategies that can significantly improve your chances of success.
Here are the common and pretty popular risk management techniques you can use;
Having a definite reward-to-risk ratio is crucial in mitigating market risk. With the reward-to-risk ratio, you quantify the risk you’re willing to take and the prospective reward for all your trades.
Essentially, you want to make more than the risk you willingly take for a position. If you’re willing to risk $200 of your capital, your prospective reward must be twice or even larger than it.
Suppose you identify a potential trade where the expected profit is $500 if successful. However, you also recognize that the potential loss on the trade is $250.
In this case, your reward-to-risk ratio is 2:1 ($500 reward / $250 risk), indicating that the potential reward is twice the potential risk.
The forex market is dynamic; it changes every time, snapping depending on several factors. If you fail to ride with the market, it’s likely for your position to suffer.
So, how do you ensure you’re riding the market trend? Well, you must analyze the market.
Analyzing the market helps you to foresee the potential direction of the market, identify opportunities, and make informed trading decisions.
When you analyze the market, you use two types of analysis;
Remember, these two are not mutually exclusive to each other. Using both analyses in your trading plan may give a great probability of success.
Assume you want to trade EUR/USD. You conducted a thorough analysis of the forex market and found that the EUR/USD will potentially rise in value because of the technical indicators and positive economic data from the Eurozone.
With this, you decided to enter a buy (long) position on the EUR/USD because your analysis suggests that the market will experience an upward trend.
“How big should my position be?”
That’s one thing you need to ask yourself before entering a trade. Remember, your answer must be based on your risk appetite, trading account health, and the current market condition.
If you define the suitable position size, you control the capital you can risk and protect your trading capital.
Suppose you have $10,000 in your account and decide to risk no more than 2% of your account in every trade. With this, you can only invest a maximum of $200 in all your trades.
But the question is, can you access and profit from the market with only $200? Well, you can trade with leverage using margin trading.
The stop-loss (SL) order is a trading order you can use to manage and mitigate potential losses.
When you set an SL order, you instruct your broker to automatically and immediately close your position when the market reaches your SL order. This way, you avoid having your position suffer further if the market moves against it.
Suppose you’re analyzing the market and the news releases; you noticed an opportunity to go short on the EUR/USD. With that, you entered a sell position at 1.2000 market price.
To manage risk, you set your SL order at 1.2050, ensuring that potential losses are limited to 50 pips if the trade goes against your position.
The 1% capital rule is famous among forex traders. This risk management technique is mainly used to prevent traders from overexposure to a single risk.
Simply put, it says you shouldn’t risk more than 1% of your trading capital on a single trade. This way, when the trade has experienced substantial losses, your trading account still has the means to handle it.
Assume you follow a 1% capital rule and have $50,000 in your trading account. Essentially, you limit your risk exposure to only $500 per trade.
Regardless of a trade's potential profit or loss, you ensure that the maximum risk does not exceed 1% of their total account capital.
Through this lesson, you’ve explored how having a risk management technique helps you in the risky scene of the forex market. For the next one, you’ll better understand how much capital you need when trading forex.