Tips to Improve Risk Management when Trading Forex
Tips to Improve Risk Management when Trading Forex
Whether you're trading Forex currencies or CFDS on metals or any other commodity, risk management should always remain a key part of your trading strategy. Risks will always be present in the financial markets, whether because of a sudden unexpected market movement, a lapse in discipline or a technical glitch (and so on) and since they cannot be avoided, risk management must be implemented in order to avoid unnecessary losses.
Risk management involves appropriately managing your invested capital to keep your losses to a minimum. To do this, you need to:
- Understand the risks involved in forex and CFD trading
- Recognise those risks and learn to evaluate them
- Understand your trading style
- Stringently follow a tried and tested trading plan and trading strategy
- Practice new strategies on a demo trading account before executing them live
- Find solutions to reduce risks
- Manage and apply those solutions consistently
Begin trading on a demo account
A demo trading account provides you with identical tools and facilities from live forex and CFD trading, placing you are in a simulated trading environment that allows you to trade under live market conditions, without the stress of losing real funds.
No matter how anxious you are to begin trading forex, it is highly advantageous to begin with a demo account first, as this will help you to understand where your trading weaknesses lie and work on those weaknesses before getting started with live currency trading. In addition, you will be able to learn how to effectively manage risk when it comes to live trading. Once you feel confident enough in your understanding of the market and the risks involved in trading, you should begin with live trading. Experts suggest a minimum of one month but a maximum of three.
Forex and CFD trading with leverage: Is it worth the risk?
Trading forex with leverage can be an exciting endeavour. The opportunity to amplify the value of your trades is available right at your fingertips, meaning you only need to deposit a small amount of money into your forex trading account to control huge contract volumes.
For example, if your forex broker offers a 50:1 leverage then you can enter a trade worth $50,000 with an initial deposit of $1,000. A forex broker that offers a 100:1 leverage can enter a $10,000 with a margin deposit of just $100.
Although forex trading with leverage sounds incredibly appealing, it's essential to consider the risks, as the higher the leverage, the higher you gain profit or loss. Always assign a certain percentage of your trading account balance to your margin deposit and use leverage conservatively, keeping in mind the risks. Too much leverage is irresponsible and risky, and although there are short-term benefits to trading with leverage, there is no wisdom in overleveraging.
The trading plan
Trading forex naturally comes with a certain level of risk, and as a result, it is important to create an effective trading plan. Since your money is on the line when trading FX online, having a solid trading plan – and sticking with it – not only makes trading much more straightforward, but is one of the easiest ways to manage risk.
Without a trading plan you will become lost amongst your trades and be more likely to trade on stress, emotion and gut instinct, which is much more likely to result in huge and irreversible losses. To contrast, when you follow trading plan carefully you are most likely trade with discipline, patience, objectivity and zero emotion. As Chinese military general Sun Tzu famously once said, "Every battle is won before it is fought." As the phrase implies, planning and strategizing – not battling – can make all the difference between success and failure.
The risk:reward ratio
Before entering a trade always measure the risk to reward ratio (risk:reward), where risk is the amount of money that you may lose in a trade, and reward is the profit that we can make in a trade. Always keep your trading plan to hand and follow it meticulously. If the risk:reward ratio doesn't match your requirements, avoid the trade.
The recommended risk:reward ratio is 3:1, which gives you the potential to make 3 times more than you are risking. Of course, these can be adjusted depending on the time frame, trading environment and entry/exit points, but trading with this ratio gives you a higher chance of achieving long-term success.
See the chart below as an example:
In the example above, even if you only won 50% of your trades using the 3:1 risk:reward ratio, you would still make a profit of $10,000. As you can see, when you trade with a good risk:reward ratio, your chances of making small, consistent profits are increased, even with a lower win percentage.
Drawdown is the reduction of one's capital after a series of losing trades, and is calculated by getting the difference between a relative peak in capital minus a relative trough. Drawdown is part and parcel of trading forex. In order to survive losing streaks and avoid a large drawdown in your account, you should only risk a small percentage of your account per trade, as the more you lose, the harder it is to make it back to your original account size.
If you read The 5 Biggest Mistakes Forex Traders Commonly Make, you know you should not risk more than 1% of your capital in each trade.
Implementing stop loss and take profit orders
To control the impact of losses on your forex trading account it is essential to set stop loss and take profit orders, which prevents losses of more than 1% on any single trade.
Stop loss and take profit are predetermined exit points established before executing a trade. With the stop loss, once you execute a trade that trade will automatically close if the price of a currency drops to a certain level, ensuring that your losses are not too impactful on your trading account. Likewise, with the take profit order, your trade will automatically close if the currency price rises to a certain level.
Stop loss is an excellent risk management strategy that enables you to cut your losses short and walk away from a potentially dangerous trade. Though being in a losing position is oftentimes inevitable, by implementing stop losses we can control how we respond to the situation. Now is the time to accept that this particular trade was not profitable for us, but that there will be plenty of other opportunities presented to us in future.
Despite their benefits, remember that if stop loss/take profit orders are set too narrowly, this can lead to your order being closed on a minimal market movement, so do your research carefully before choosing the appropriate stop limit.
The best place to practice trades and test out stop limits in different scenarios is on a demo account. If you have a live account, you can also use MT4 extensions, such as the Admiral Markets trade terminal function, which displays the indicative risk for stop losses in your account's currency:
Taking risk management seriously
Forex and CFD trading is a high-risk activity where the markets can move against us in the blink of an eye. As such, there is absolutely no way to trade forex without encountering losses at some point or another. However, there are some investors who are more likely to experience a higher percentage of gains. This is because they create consistent risk management measures ahead of time, which they follow meticulously.