How Can You Manage Your Risk?
In this guide, we are going to explain what risks are involved in trading Forex, and how you can manage your risks to protect your trading capital and also your mental well-being. Why do we talk about mental well-being? Well, any time you are facing risk, your mind can descend into turmoil and confusion. In this state of mind, you end up making poor decisions. You may either take on too much risk or you may freeze and be unable to get into a trade for fear of it going wrong. These issues are what we will address. By the end of this guide, you will know how to handle risk and how to manage your trading account like a pro.
Let’s start this guide with a quote by Jesse Livermore (1877 – 1940). He said, Being wrong – not taking the loss – that is what does the damage to the pocket book and to the soul. As we have said a few times in this guide, success in trading is often less about the wins and more about how you handle the losses.
Risk is part of life. It is impossible to avoid risk completely. But, we humans are a bit weird. Why? Because we continually try to judge risk and then accept or reject risk based on our perception of risk. In trading Forex, for novice traders, this is a big area of struggle.
Trading Forex Has a High Degree of Risk
There is the risk of losing money and also the risk of each trade. In this guide, we will focus on financial risks because we intend to teach you how to protect and manage your trading capital. If you fail to manage your money you will end up like the vast majority of new traders and lose your capital. Once stung by heavy losses, it can be hard to rebuild the mental resilience to get back to trading without fear. And we don’t want that for you, so let's begin.
Let’s imagine you open a trading account with £1,000. In the first month of trading, you lose £100. This represents 10% of your capital. Your capital is now £900. In your head, you think you need to make 10% back. But, in real terms, it is a bigger percentage than you think. To calculate the percentage of profit you need to restore your balance to £1,000, do the following equation –
£100/£900 x 100% = 11.11%
OK, so the next week, you lose another £100. Your balance is now £800.
£100/£800 x 100% = 25%
This sounds crazy, doesn’t it? But, do the maths and you will see it is an objective process. The more you lose, the more profit you have to make just to get back to your start balance.
This is why it is important to continually remind yourself of an important principle –
“Protect your trading balance at all times…”
So much is written about how much money you can make in Forex trading but the losses tend to be ignored. Why? Well, no one wants to admit that losses are inevitable. The focus of most novice traders is on the win. When, in reality, paying more attention to potential loss will switch your mindset to an objective assessment of risk on EVERY trade you take. Instead of asking yourself, “How much can I win?”Ask yourself, “How much am I prepared to risk on this trade?”
Why focus on losses? I just want to make money!
Of course, you want to make money but hear us out.
Talk to any successful, professional trader and they will tell you that their pivotal point in trading Forex occurred when they switched to thinking about the potential risk of their trades. They will tell you they had to learn to lose before they learned how to win. Yes, it may sound crazy, but it’s an occurring theme for the traders who rise out of the failing 95% to the heady heights of the elite 5% of traders making money consistently from their trading.
Why do we Have to Learn How to Lose with Forex?
Trading Forex is essentially a battle with yourself. Did you know that the brain is twice as reactive to losses as it is to gains? It’s true. The brain wants to keep you safe. But, when we start trading, our brain reacts to potential loss as a threat. Your emotions go haywire.
There are two areas in trading where your emotions may get the better of you:
1. Dealing with a potential loss
sometimes you will see a trade going the opposite way. Professional traders know how to cut their trades short. Novice traders are reluctant to lose their grip on their belief in the trade. The desire to be right keeps you holding onto a trade way too long
2. Dealing with lost profit
The Forex market can be like watching the waves of the sea coming in and going out. You see your open trade moving in the right direction. It’s in profit, hooray, it’s all working out. You feel happy. You were right. Yay. You go off for a coffee, a walk or a chat with a friend to tell them what a brilliant trader you are. You feel so good you got it right.
Then you return to look at your trade. What! What happened? The price retraced and all of your potential profits have disappeared, Profits have shrunk or the trade is now in a position of loss. Now you beat yourself up for not taking the profit when it was there. You go through all sorts of mental anguish, wondering what you ‘should’ have done.
So, you are wondering how to overcome these frustrating aspects of trading? How do you know when to close a trade or when to take your profit?
Look at the image below:
The trader took a long trade based on the daily chart. GDPJPY was in an upward trend but the price had pulled back to a support level. The trade went in and out of profit for three days. The trader considered closing the trade but held. The risk to reward ratio was 1 to 4 with a small stop loss of 0.5% of capital. Look at the trendline tracking the falling price. Just when it looked like the trade had failed, the price jumped way above the falling trendline, and it continued to rise to hit profit...
What’s the point?
Do your analysis, take the trade and walk away. If you have done the work, let the trade run. Yes, you can close the trade if it’s going against you but if your stop-loss is small, let it play out. Accept the outcome either way.
This activity (or lack of) in the market, can be one of the most frustrating aspects of trading Forex. With a 0.5% risk, the trader fully accepted either outcome.
The point is, the market often tests you to your limits of experience in the market. Over time, and with practice, you will come to understand this is how Forex works. If rarely does exactly what you want it to do. So, this is why it is VITAL to measure and accept your risk 100% of the time…
OK, so how do I measure my risk?
Firstly, you must learn to accept a loss. If you cannot, you will become one of the 95% of traders who blow their accounts or cannot continue trading because it’s too frustrating to keep losing. You will know you are making progress when you are cool about your losses and not overly excited about your wins.
Accept you will make mistakes. This is perfectly normal. What differentiates a good trader from a failing trader is the ability to learn from mistakes. When something goes wrong, assess the trade.
Ask yourself questions like –
- Did I get into the trade too quickly?
- Did I buy in an area of resistance, or sell at support?
- Did I miss upcoming economic news
- Did I assess a potential reverse position from my trade? It’s important to get an independent view of the market. This helps to eradicate bias. For instance, you have done your analysis and decide to trade a buy. The trade loses. You go back to look at the chart and see all the selling signs you missed. Confirmation bias disappears once the trade is over. You will slap your head and say, “How could I have missed that?”
- Did I risk too much?
- Did I wait too long to enter the trade?
There are hundreds of questions you could ask after a losing trade. And, it’s equally important to assess what you did right after a winning trade.
Let’s look at the practical steps for managing your Forex capital.
The first thing to do when you are trading Forex live is to decide how much to risk. It’s better to work in percentages than by monetary risk. The general rule is to only risk 1% of your trading bank on each trade. Let’s imagine you have a balance of £1000. For each trade you take, you are risking £10. You would have to be ‘wrong’ one hundred times before your trading balance was zero. Now, imagine you are risking 10% instead of 1%. You only need TEN losing trades to annihilate your account. Wow! Doesn’t that put it into perspective?
Plan your trades well, aiming for a minimum 1 to 2 risk to reward ratio. Look for trades where you can take a smaller stop loss. WAIT for these trades to come to you. Patience is king and will help you to trade with minimum risks.
What Are the Other Benefits of Risking 1%?
One of the biggest benefits is that, because of the minuscule risk to your account, you won't go into meltdown with stress over an open trade. You can confidently place a trade knowing it won’t significantly dent your account if it goes wrong.
The biggest factor for novice traders ignoring this advice is they think it will take ages to grow their account. Greed takes over and they start placing bigger trades. They think one big win and they’ll go back to smaller trades. It doesn’t happen. One big win and you get cocky. Suddenly you believe you are the greatest trader ever lived. You’re a natural and you can’t lose. Well, wave goodbye to your account because we guarantee it is only a matter of time before you hit a big losing run and suddenly you are getting a margin call from your broker.
Remember the story of the tortoise and the hare? Everyone assumes the hare will win because he is fast. But the tortoise keeps going steadily until he reaches his destination. Growing your account in small increments WILL get you to your destination. And remember the power of compounding. As your account grows, the balance gets bigger so your profit percentages grow whilst still only risking 1%
- Accepting risk can bring you closer to becoming a successful Forex trader
- Assess the risk of a trade by looking at the opposite scenario to the one you think may happen
- Focus on protecting your trading capital at all times
- Accept growing your account steadily – patience brings rewards
- Remain philosophical in regards to wins as well as losses
- Confirmation bias can get you into the wrong trade
- Assess your trade after a win or a loss by looking at the charts
- Money management leads to success
- Only risk 1% of your capital balance
- Seek the best risk to reward opportunities for a low-risk trading plan to maximise growth on your capital.
Now you know how to manage your risk by applying the 1% guidelines. You understand that the Forex market can be frustrating and cause you to make poor decisions. The main takeaway is that you must protect your trading capital at all times if you want to stay in the game and become a successful Forex trader. Consistent capital growth comes from compounding, incremental gains based on making good decisions with every trade.
In the next guide part, you will learn about trading plans and whether you need to have one.