What is the Best Risk Management Strategy for Trading Forex?
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First and foremost when you make the decision to learn to trade forex, you should do so with the view that you are embarking on a business enterprise, not simply an investment, or some speculative opportunity. From this perspective, you are aiming to make it profitable by ensuring you have a business plan that not only creates opportunities to make money but also has a built-in strategy to guard against making damaging losses. This strategy is best described in forex trading as risk management.
As with any business you need to understand the arena in which the business operates to know why these risks exist and there is no better starting point for achieving this than our free trading course, available here. Your decision to learn forex trading thoroughly, rather than just diving into it, will prevent many costly mistakes and will be time well spent.
Our free course gives you a good insight into the nuts and bolts of forex trading. However, this article highlights those factors within your personal trading methods that require the most vigilance on your part if you are to rise above the 90% of new traders who fail to make money to become one of the 10% who do succeed and go on to make a consistently good living from it. Risk management for forex is the one element in forex trading that cannot be overlooked.
What follows is what we believe to be the best risk management strategy for anyone embarking on learning to trade forex. Although this is especially relevant for people new to forex trading, it encompasses disciplines that are equally important to seasoned traders and will become second nature to you as you become one of them.
How to create a risk management strategy inside your business plan
Although banks offering business loans do not generally regard forex trading as a serious business opportunity, you need to see it this way. The capital you put in to start out on your trading venture and its subsequent increase is the only thing that keeps you there so that money needs to be properly managed from the outset. There are many factors that will determine how well you do in this business, but none is more important than good money management.
Therefore, the risk management strategies that follow are centred around the issue of how well you manage your money as a forex trader.
Strategy 1 - Ensure that the size of your investment is a realistic reflection of your expectations
One of the biggest mistakes new forex traders make is to expect to turn a 500 Pounds, Euros or Dollar deposit into a 2000 return on their first few trades. In some circumstances, this can occur, but it is highly unlikely and will be more the product of temporary good fortune than anything that is likely to be sustained. This is not a horse race, nor a poker game. It is a monetary action plan that is ongoing and reliant on constant observation and strategic decision making.
Starting out with a small amount of capital is a great way to test how this business works with real money, as opposed to simply paper trading, but this should be seen as part of your trading education, rather than something that will bring you overnight financial success. Please refer to our articles, 'How to Trade Forex with $100' and 'Is £500 Sufficient to Start Forex Trading?' for further insights on this.
The first goal when you start trading forex is to develop a trading plan that protects the main body of your capital while using a workable portion of it to make trades that have the potential to increase that capital. Whether you are using $100 or $100,000, your expectations should focus on increasing that amount by somewhere between 20% and 60% over a predetermined period of time - say twelve months. This may sound rather conservative, compared to what a lot of the hype around trading forex suggests you can make, but it is far easier to go in with realistic expectations when starting out than with wild hopes that can easily be dashed after your first few trades.
There is nothing to stop you adding to a modest deposit once your trading plan bears fruit, but it is unwise to throw good money after bad if your initial investment dwindles to the point where you can no longer make trades. At that point, it is better to take a break from trading to gain a better understanding of the forex trading business and the way you participate in it. Once again you are referred to our free forex trading course as a means of adding to your forex education.
Strategy 2 - Learn to manage your emotions
Understanding and measuring the movements in the many currency markets that exist within the forex arena constitutes much of the learning that underlies the trading decisions forex traders make. Fortunately, there are now many aids to access this information, but the amount of information available and the depth of detail in some of it can be overwhelming - especially if you are new to forex trading or early in your quest to learn how to trade. Remember what we advised at the outset: learn to trade before you dive into forex trading.
Not surprisingly, this overwhelm can lead to bad decision making and reckless trades that should be off-limits if you are following a strict trading plan. This, in turn, can lead to an emotional need to get back to where you think you should be financially by trying to find a quick way to recoup your losses in much the same way as someone, who caught up in chasing their losses in a casino or on the racetrack. If this happens to you, you need to take yourself out of the market and take time away from trading until you are ready to start afresh.
If you have a gambler's mentality and respond emotionally to the small losses you must expect as part of your trading activities, or the occasional errors of judgement you may make along the way, this may not be the right business for you to be involved with. It is very easy to get emotionally and psychologically caught up in the twists and turns of market activity and to try second-guessing what will happen next, but that is a losing strategy that has no place in the mind of anyone wanting to engage with forex trading as a business.
As far back as 1980, before forex moved onto trading platforms to gain the public popularity it has today, a stock and commodity trader called Jacob Bernstein wrote a book called 'The Investor's Quotient', which focused on the psychology of successful investing in commodities and stocks. In it, he identified those personalty types most likely to succeed as traders in fast-moving markets and those susceptible to sabotaging their prospects of financial success. You don't need to read the book, excellent though it is, to find out where you stand in this regard, you only need to observe how you react to the play of the market forces you are trading. An honest assessment of how well suited you are to this kind of activity will stand you in good stead for the challenges that lie ahead.
Strategy 3 - Make self-discipline your friend
When you trade forex, there will be stop loss points in your trading plan that safeguard you from experiencing losses greater than those you are prepared to risk. Keeping these in place when the temptation to raise or lower them in the hope that the market will turn around in your favour is a discipline you must adhere to. Losses must be accepted as an acceptable outcome of any trade before you take any position in any market. This is fundamental to your risk management strategy.
A related discipline is to stick to your profit taking point once it has been reached. It is all too easy to be swept up with optimism when a market moves your way in the belief that it will keep on moving that way. It may do, but you don't know that, nor at which point it will turn around. If you make a trade that is designed to make you $200 if it works out and loses you $50 if it doesn't, keep with that decision and take your profit or loss accordingly.
Another important discipline is to always trade within your comfort zone. There is a general rule of thumb that suggests that no more than 1% of your capital should be at risk in any single trade. This way you can ride a poor run of losses without it compromising your trading plan as a whole. If you get overzealous and pile in on a trade where a far greater amount of your capital could disappear, this will take your focus away from any other trades you may be looking at and carries the added risk of bringing emotional upheaval into your decision making.
One further discipline to mention is to keep your trades manageable. Over-trading can muddle your thinking if there is too much to monitor at any given time. Holding too many positions can also leave you open to issues with margin calls if too many are in a losing position at the same time, or market volatility in one raises the amount of capital required to remain in that market. In the worst case scenario, you could be forced to exit trades that have yet to reach your profit taking point to cover liabilities in others that are doing less well. The best way to avoid this is to select a small number of currencies to focus on and get to know the feel of them over time. Then you will have a better sense of what the risks are and not be subject to wading into unknown territory where unfamiliar market forces may surprise you.
Strategy 4 - Guard against the impact of the unforeseen
Forex markets, perhaps more than any other trading markets, can be extremely volatile and fast moving. No matter how exacting your research or proven your trading plan, things can happen that underlie the market action you are trading that can turn a currency around in an instant.
Right now the continued uncertainty in the UK's Brexit plans is causing big shifts in sterling related markets everywhere. With Brexit just days away from its conclusion, the merest rumour of something that may or may not prevail can cause massive fluctuations in those markets. If you are trading any of these the market activity alone will require a far bigger margin than you may have needed in the past.
Fluctuating margins are not uncommon if the market concerned is very active. Of course, it isn't just the margins that you need to take heed of, but your actual trading position in a lively market. If you have a position on a Friday afternoon in a volatile market, you may want to exit that position before the weekend as you could be in a very changed situation by Monday.
See also: What Are Price Gaps in Forex Trading
Strategy 5 - Be prepared to be wrong
Even the greatest traders and investors agree that there is no certainty that any market can be consistently relied upon to act in accordance with its history. Only the market knows what it is going to do next and that just a few moments before it happens. You can't make a trade that quickly.
As traders, we analyse the effect that events of every kind have on market movements and observe trends that have a tendency to re-occur in certain conditions. With the tools and guidance systems at our disposal and whatever capital we have managed to accrue, we aim to predict which way a market will move to the best of our abilities and back our judgement with hard cash.
If we are strong willed, disciplined and solvent we can profit from this and that, of course, is the goal of every forex trader. But we are cautioned to remember that if this business was merely a science with a set of consistent properties and rules to learn, anyone could master those in time and make a success of it. But this is not the case. Trading, whether in forex or any other market, is an art that depends as much on the way we interact with it, as on the knowledge we accumulate about it.
Successful traders never stop learning ways to improve their performance in the markets and having a proper risk management strategy in place is a vital part of that.
Whatever stage you are at now, it is always worth adding to your body of knowledge. To assist you with this, we offer a free course on forex trading that is accessible right here. Learn to trade with us today.
If you want to learn more about forex trading make sure to visit the archive of forex trading article on our website here and browse even more useful, inspirational, and educational content.
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