The Forex market is a place where international currencies are bought and sold by traders with the anticipation of earning profits from favourable fluctuations in exchange rates. But the profitability of a forex trader depends on their ability to manage the risk that comes from the volatile nature of currency pairs. The forex market is huge; thus, the market risk you are exposed to as a trader will also be huge. Traders who fail in the forex market often focus on making profits while underestimating the risk they take with each trade. However, this approach will never take them to their goals.
Traders should focus on managing their losses; profits would come automatically if their market analysis is correct. There are trading tools available with the brokers that can be used to determine the right lot size, leverage, stop loss and take profit levels, so traders should use such tools. Risk management plays a key role in surviving in the market, and all traders must keep this in mind.
Today we will cover 5 powerful risk management tips that can help you attain your goals as a forex trader.
Basics of Forex Risk Management
The amount of risk you take as a trader is crucial for estimating your chances of success in the forex world. Risk management in forex is not about avoiding the risk as a whole because trading with risk is simply impossible. A moderate amount of risk should be taken for every trade you enter, but risking too much would only lead to huge losses, which often end up badly for a trader. You will hear many stories about traders blowing up their trading accounts, where they lose the entire trading capital they had brought for trading. This is surely not the right way to enter the market, as safeguarding your capital and minimising potential losses is the first step towards profitability.
In trading, losing little is as good as making some profits. So, cutting your losses early will always be the key rule in risk management. But at the same time, you need to make sure that you are not limiting your potential for profits, as being too risk-averse will only leave you stuck as you simply don’t take enough risk to hit your profit targets. So, risk management is about striking a balance where you take calculated risks and trade with a rational mind relying on market analysis and without deviating from your trading plan. Understanding your risk profile or risk tolerance is the first thing you must do to devise a perfect risk management plan.
Decoding the Risks of Forex Trading
- Market Risk – The market risk of forex trading is hard to escape, even for the most experienced trader. No one can be 100% sure about the market’s direction, even after detailed fundamental and technical analysis. The currency market is volatile, to begin with, and there is an element of unpredictability that comes as a result of various economic and political factors. As forex traders, we do our best to predict the most probable scenario and plan our trades based on that. But our analysis, calculations and predictions can often go wrong, which puts us at risk of loss while trading.
- Risk of Leverage – Leverage is actually a great tool which allows forex traders to make the most out of their trades without having a huge amount of funds, to begin with. When we avail leverage, we are able to open larger trade positions with a smaller margin in our trading account. The use of leverage enhances your profit potential, but it also accelerates the risk of loss. Using excess leverage will cost you a lot as a trader, so you must be cautious while trading with leverage.
- Risk of Choosing the Wrong Broker or Platform – Another risk for beginners who trade in the forex market is choosing the wrong broker or platform. Finding a reputed and regulated broker is not that hard, as we have many good options to consider. But traders often end up with the wrong broker due to a lack of knowledge and misinformation. There are many cases of traders who lose their money by dealing with scam brokers, and this is one risk that you shouldn’t be putting yourself at while entering the forex market.
- Lack of Knowledge – Now, the last but the biggest risk that many beginners make is getting into trading without enough knowledge. Lack of knowledge and skills result in the worst risk as you simply don’t know how to navigate the markets on your own. So, doing proper research and sparing some time to learn about forex trading is essential for eliminating this risk as a newcomer in the volatile currency market.
5 Ways to Manage Risk in Forex Trading
- Choose the right broker – The next tip for risk management is to choose the right broker. Make sure they are regulated and reliable. To be certain, open a demo account with them and test the trading conditions. Once you are confident about their reliability and performance, you can open a live trading account. The general traits of a good broker are – minimal slippage, fast processing of withdrawals and prompt customer support, so if you find a broker with these traits, just go for them.
- Setting an optimal Risk/Reward Ratio- As we mentioned in the beginning, risk and reward are inseparable, which is entirely true in the context of forex trading. So, setting an optimal risk/reward ratio is Forex’s first step towards risk management. A higher risk/reward ratio will make trading less stressful as you don’t need to be concerned about winning every trade you enter. A 1:2 risk-reward ratio or higher is ideal for most traders as it allows you to limit your account drawdown even with a lesser win rate. And when you are done making profits, use a profit calculator to calculate the exact amount you have earned and note it down in your trading journal for records.
- Paying attention to position size- Another tip that we can give you for risk management is to pay at most attention to position sizing. The size of your trade positions is directly related to the amount of money you risk for a trade. The golden rule followed by the majority of traders is limiting their risk per trade to 2% of the account balance. If you have a $1000 balance in your account, You should not risk more than $20 on a single trade.
But determining the appropriate position size is a tough task for beginners. Hence, we recommend using tools like trading calculators, which can come in handy for trade-related calculations. You can easily find such tools on broker platforms, and adding them to your toolkit would be ideal for simplifying the position size calculation process.
- Setting stop loss for every trade – Trading without a stop loss is like driving without a seat belt. Hence you must place stop-loss orders and limit orders for every trade without fail. You also need to set a stop loss at the right price levels as the stop loss being too tight would limit your profit potential, and on the contrary, a wide stop loss will invalidate the purpose of setting a stop loss in the first place. Stop loss is the automated exit point when you end up losing the trade, and you must place it in accordance with your risk profile and trading style.
- Learn to use Leverage properly – As we mentioned earlier, trading with leverage adds more to the risk of loss. The key to avoiding this risk is learning to use leverage in the best possible manner. You don’t need to let go of the opportunity to use leverage, as it is a great tool for retail traders who aspire to earn more profits. With leverage, you can target small pip movements to make decent profits, which you can then calculate in your own currency with the help of a pip calculator. However, leverage also has certain downsides, like it can wipe out your capital if your market analysis is wrong and there is a sudden downfall in the market. So, make sure to have a strict SL in place to avoid big losses. Just keep in mind not to lose beyond your losing capacity.
So, these are the 5 powerful risk management tips you must follow to save yourself from unwanted losses in the forex market. But one more thing you need to remember while trading forex is managing your emotions. Because emotional trading and impulsiveness are bound to get you in trouble when you start trading for real, you need to make conscious efforts to avoid emotional trading and stick to your strategy. If you keep these points in mind, you can trade forex with minimal risk.