Risk Management in Forex Trading

Risk management is an important part of every business and investment. Even those who do the business of buying and selling goats face risks. You buy a goat at the market price and plan to sell it during the next auction, expecting the price to rise. On reaching the market, you find that there are so many goats on sale, pushing prices below your buying prices. You either short yourself at the current prices or go back home and wait for the prices to rise. Even then, you will incur opportunity costs in terms of the waiting time between the day you bought the goat and the time you will sell your goat at a profit, if at all the prices will eventually rise.

Forex trading applies the same principle. You might have analyzed the market and saw a sell opportunity for EUR/USD. Unfortunately, the market price goes against you for quite some time. You either wait for the prices to reverse or stop loss. If you choose to wait, it might take days or weeks before the market reverts to a bullish trend. Again, the turnaround you are waiting might not happen. If it does, it might happen when you have already received a margin call. So what do you do to manage your risks and ensure you stay in the market? You should follow risk management rules obediently. Basically, risk management is about controlling your losses.

That is where you hear people talking about discipline in Forex trading. You don’t just jump into a trade because you have seen an opportunity of stomaching huge profits. Hold your horses, set your rules first before delving into the trade. Moreover, Risk management can make you rich in the long term if you use it appropriately.

Here are six ways you can manage risks in Forex trading:

  1. Do not Use Money That You Cannot Afford to Lose

Do not use your school fees to trade Forex. Losing money is a normal situation in the life of a Forex trader. If you are not prepared to lose, do not trade. This business is for risk takers, and that is the painful truth. Well, every business involves some risks; but in Forex trading the risks are exacerbated by high leverages. So to minimize risks in Forex you need to use money that you do not need.

  1. Use Stop Loss

Many people do not fancy a stop loss, but it is actually better than a margin call, which is a complete or significant erosion of your equity capital. A stop loss is an essential tool that was ingeniously developed to help you protect your positions from unexpected changes in the market. When you are opening a new trade, you should set a stop loss a few pips above or below your entry point. When you are selling, you set stop loss above your entry point. When you are buying, you set stop loss below your entry point.

If you buy EUR/USD and USD becomes stronger unexpectedly, the prices will start going down. Sometimes the prices will go down and rise afterwards. At other times, the prices might fall far beyond the level that your margin can accommodate. In this case, a stop loss will close your trade before you lose too much of your money. Accept the loss, and look for other profitable opportunities. If you are stopped out consistently, perhaps you need to educate yourself more about Forex trading, or change your strategy. The key principle about stop loss is to set it at a point where you don’t lose more than 2% of your capital.

Watch this video on how to set stop loss and take profit on Meta trader:

https://www.youtube.com/watch?time_continue=158&v=nnQYYSbMfuQ&feature=emb_logo

  1. Limit your Leverage

What I like most about Forex trading is that it allows people to trade huge volumes of assets with little amount of money. This is possible through something known as leverage. In a nutshell, leverage enables you to multiply your profits or losses.

For instance, a leverage of 1:100 means that you can take a position worth $100,000 with only $1,000 in your account. If the trade moves in your favor, your profits will come from the $100,000, even though you invested only $1,000. With only $50, you can trade with currencies worth $5,000; hence magnifying your profits or losses exponentially. You can also trade with a leverage of 1:200 or 1:400.

While high leverages will give you larger profits, it can also earn you massive losses when the market goes against you. This increases the chances of getting a margin call, or losing your capital entirely.

Generally, higher leverage increases your risks. Retail traders who trade with small amounts of capital below $1,000 should use a leverage of below 1:50 to minimize their exposure to risks.

Professional traders who use thousands of dollars to trade forex can use leverage of over 1:100. The more your capital, the higher the leverage you can choose because you have lesser risks of losing money when you trade with a larger equity.

  1. Create a Trading Plan

Some amateur forex traders enter the market and start trading on instincts, and then leave the market as hastily as they entered. To minimize risks, you should not rely on your instincts too much. Furthermore, you should not rush to trade based on news all the time. These might give you lucky wins a few times, and before you know it, the market punishes you. You may be lucky with four-five trades, but you cannot always be lucky. Your profits should be based on a well thought-out plan. You should know when to:

  • Enter the market
  • Leave the market
  • Take profit
  • Accept loss

In your trading plan, you should identify the entry point, whether in a dip or on a rally. Once you identify your spot, identify a possible point where you will take profit. For instance, if you are buying you can target the next major resistance level as your take profit level.

You must also have a plan of what you should do if your trade goes against your expectations. If you doubt whether the trade can reverse once it goes the opposite direction, set a stop loss some few pips below your entry point.

In sum, your trading plan helps you to set your entry and exit strategies. You must follow that plan faithfully. Do not make the mistake of telling yourself, “perhaps I should wait a little longer, the prices might go beyond my expected level.” Be disciplined and stick to your plan.

  1. Diversify Your Portfolio

One of the best investment strategies I know is to diversify your asset portfolio. Like other classes of assets, forex portfolios help you minimize risks. If you trade in diverse currency pairs, you stand a good chance of making profits.

Let’s say for instance that you have made your analysis in four pairs (USDJPY, EURUSD, EURCAD, & GBPJPY). You have identified a trade signal in all four. You have also set a stop loss and take profit in all of them. Let’s also assume that each stop loss gives you a loss of $2, while each take profit gives you a profit of $8.

  • If you lose in two trades and win in two, your final profit will be -4 + 16 = +12.
  • If you had invested in two trades, you win one and lose one, you get -2 + 8 = +6.
  • If you have one trade and you lose it, you get -2.

Clearly, the more the trades, the lesser the risks and the more the profits.

  1. Check Your Emotions

Another important thing you should consider in Forex trading is to control your emotions. On many occasions, I have closed trades that could have given me more profits if I had waited. I have also entered the market at the wrong time due to some movements I have seen or news I have heard.

Emotions can make you do things against your plan and affect your sense of judgment. With all information available, you analyze a trade and make a decision. While monitoring your trade, which is key in forex trading, you notice some movements that distort your sense of judgment. Check those emotions.

Be objective if you have to manage your risks effectively.

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