What Is the Importance of Risk Management in Forex Trading?
Risk management in forex trading is the most important thing you’ll ever learn as a trader!
Forex trading can be a roller coaster ride for unprepared traders. But, like any other form of investment, if you have strategies in place, you could even get to turn your forex dealing into a full-time career.
One major area any forex trader needs to find out about when they learn to trade is the significance of risk management.
Risk management in forex trading should be at the forefront of your trading strategy.
Before thinking about how much you want to make from trading, you need to be thinking about protecting what you already have!
If you lose it all, then you’ll never make your profit. You’ll have to quit and won’t get your break to trade again for a long time.
Risk management is a concept that has existed for a long time and is relevant to all kinds of trading and all kinds of business ventures.
Every time you make a decision, you rake up the risks in your head; what are the likely outcomes and is the potential result worth it?
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Forex trading can be a lot of fun for anyone making the effort to learn to trade, however, lots of people start trading and give up after experiencing one or two losses.
One of the things you need to understand at the very start of your forex trading activities is that you are bound to have losses.
However, once you’ve mastered the art of trading, you’ll learn just how to mitigate your financial risks and begin to launch your own successful trading career.
You can earn substantial sums of cash from successful forex trading and our useful guide to forex trading and how it works will give you a head start if you plan to start trading forex immediately.
This comprehensive guide explains all about currency pairs, forex spreads, and leverage, but doesn’t go into too much detail about risk management in forex trading.
That’s the reason we’ve posted this article, to offer all our trainee forex traders bang up to the minute info on the management of risks in forex trading.
What is risk management in forex trading?
It’s recognised that up to 90% of new forex traders lose cash in their first few forex trades and many of them will give up trading at this point.
But forex is a massive global financial market and over $5 trillion is traded on exchanges on a daily basis.
Traders can be active on the forex market 24 hours daily, and, what’s more, you don’t need to invest tonnes of cash into trading.
Plus, online forex broker commissions are competitive, making it easier to see profits from regular trades.
One of the most important learning curves for newbie forex traders is risk management, though.
Risk management in forex trading actually encompasses a lot of different aspects of forex trading, as we’ll find out in this article.
But the riskiest thing you could ever do is not have a plan in the first place! In such cases, you are basically gambling, which is the exact opposite of managing your risk. Having a trading plan is particularly important for exiting a trade.
Risk management in forex trading also involves abandoning strategies that no longer work. In the end, it’s all about reducing your exposure to risk in whatever form it may come.
And risk can even boil down to simple things like not signing up to an unregulated broker just because they offer a bonus.
Sure, in the short-term a sign-up bonus might be appealing, but in the long-term, you’ll be kicking yourself when you can’t get your money out!
By having a risk management strategy you can save yourself from greed. Never let it take control! Always remember to be patient, especially at the beginning.
Benefits of a proper risk management strategy in forex trading
Having a proper risk management strategy in forex trading can help you become a consistent trader and being consistent is tied to being successful in the world of forex trading.
In other words, not being consistent can be risky!
If you at the last minute decide not to follow your trading plan, you don’t know what to expect, and when you don’t know what’s coming you have a lot more to lose.
Plus, knowing how much to risk can make you feel more confident in your trades.
You’re no longer thinking about what you could have gained, you now think about getting what you aim to get.
You can then rid yourself of any frustration at not reaching the highs other traders did or anxiety of not knowing what you want from the market.
The temptation of leverage
Leverage allows you to invest more cash into your forex currency trades, potentially offering greater profits by effectively borrowing from your broker.
Leverage in forex trades can be as high as 1:1000, for example, meaning that for every £1 you invest into a trade your broker will add leverage of 1,000 x, so you can trade £1,000 worth of currency with your £1.
Of course though, different brokers have their own rules on leverage and the current allowed limit by UK and EU regulators state that major forex currency pairs should only be allowed 1:30 leverage. While less popular currency pairings can be leveraged up to 1:20.
So, with that £1, you’re most likely only to be able to trade between £20 to £30. But still, it can offer a significant advantage.
And in the US, leverage can be as high as 1:50. There are even some brokers in some countries that allow up to 1:3000 leverage, which is pretty crazy!
However, applying leverage to your trades can be incredibly risky.
If your chosen currency loses against the paired currency you will need to cover all losses made in the trade. Meaning, you will also need to pay your broker back for the money you borrowed, making your loss even greater.
But even if your trade is successful, you will still need to pay back your broker. So, even if you make a profit, your net profit will not exactly be what you get back from the trade. Brokers always get their cut of the deal!
That’s why it’s important to plan your forex risk management strategy in advance for all forex trades.
But, of course, there are plenty of stories online of one-off traders who skip this vital detail and jump straight into trading and quickly develop what is referred to as ‘King Kong syndrome’.
These are people who have never traded before (and never bothered to learn about trading!) who opened a trading account with a few thousand dollars and lost it all in a couple of days.
Why does this usually happen? They trade far too much and use far too much leverage and lose it all!
They’ll make ridiculous trades that take up a third of their trading account, plus leverage to the max. A couple of trades later and they’re finished! It’s pretty sad.
If you do decide to use leverage, stick you 1:10. There’s no need to push it to the max until you are more experienced. And if you’re a new trader, we recommend that you stay away from leverage completely!
Diversify your risk
Diversification is also highly important to risk management in forex trading. Diversification is basically not putting all your eggs in one basket.
For example, if you just trade the USD against the GBP, then you are especially susceptible to issues with that currency.
If you trade several different currencies, you can avoid difficult situations and continue trading when your primary currency is down.
We all have a different appetite for risk. Without it, we would have no chance to make money.
Low risk typically means low reward; don’t make the mistake in thinking there is ever a situation with low risk and high reward - that’s a dream.
But it is something we can aim for, though a perfect situation will never appear.
What we are willing to risk for profit is referred to as our risk-reward ratio.
Paul Tudor Jones looks for a risk-reward ratio of 1:5. That means for every $1 he’s risking, he’s looking to get $5 back. If he can’t find such a situation, he won’t make the trade, it’s not worth his time.
For him, it’s just too much risk, but for many though, a risk-reward ratio of 1:5 will be too high.
Those opportunities are not always that common. Sure, when you’re rich like Tudor Jones, you can ignore plenty of opportunities, but most of us don’t have that luxury and have to take the risk.
For the majority of us, a risk-reward of 1:2 is more realistic. 1:1 is, in most situations, is not ideal, the amount you could get back isn’t very appealing. What’s the point of stressing over something so little?
Managing your risk in forex trading
As can be seen, managing risks in forex trading can be the difference between losing a fairly large sum on your first trade or regular profitability over a longer-term.
When you manage forex trading risks effectively you will probably never be in the situation of losing all your cash.
Here are our top tips on effective risk management:
- Monitoring position sizes: Work out what percentage of your funds will be used for any trade and stick to it. So, if you have a £10,000 trading account balance (including any leverage), you may want to limit your risk by 1% or 0.5% per trade. This means you would risk a loss of £100 or £50 per trade. The other risk factor to consider is your pip risk, meaning you need to set a stop-loss order at the most appropriate point.
- Stop-losses: Placing a stop-loss order means the trade will close out after a specified total loss. You need to work out how many pips you are prepared to risk on any trade, ideally, this should be as close to your entry point as possible. You can find out more about pips in forex trading in our knowledge base. For many traders, placing a stop-loss is an absolute must.
- Take profits: Another common mistake made by new forex traders is failing to recognise the point at which to take profits. There are strategies you can use to manage the point at which to take profits. Probably the best solution for newbie traders is to put a ‘close position order’ in place to take profits at the appropriate level of resistance. Candlestick recognition and moving average crossovers are some of the other strategies used by traders, and you can find out more on our site.
- Having a trading plan: From all the above, you can see it’s vital to have a trading plan in place for forex deals. It’s important you don’t rush into trading and perhaps risk 10% of your capital on one trade, 20% on another and so on. Because this is the way to lose all your trading capital in just a few losing trades, and then you’ll have no option but to quit.
- Staying disciplined: Put discipline in place with all your forex trades, this way you can build your capital slowly but surely. You may not make thousands in a couple of days, but equally, you won’t lose thousands either!
- Keep a trading journal: A trading journal is the best way to learn what you’re doing wrong and what you’re doing right. As we mentioned earlier, risk management in forex trading is all about reducing any risks you might face. But unless you’re actively analysing your trades, you won’t be able to spot all the risks to your trading. A trading journal is the best way to do that.
- Look for ‘confluence’: Confluence means where two points meet. In forex trading, what we mean by confluence is when two indicators are giving you positive signs to trade. The second acts as a kind of confirmation that there is a good opportunity ready for the taking. However, it’s worth mentioning what you see as a point of confluence, another trader may disagree; it’s entirely subjective.
All factors of risk management in forex trading
Our brief forex risk management guide above really just scratches the surface of risk management for forex trading. It’s a pretty hefty topic when you do a deep dive!
You would be well-advised to register for our forex trading course to learn more.
Once you’ve mastered the disciplines noted above, one other major risk management factor for all forex traders is to limit the use of leverage to levels that are more comfortable if losses are made.
This way you’ll be sure to hold onto your trading capital for a longer period of time.
And, finally, risk management in forex trading is probably the most important lesson to learn. If you understand all the risks you face when forex trading, and plan your trades accordingly, you will have lots more trading fun!
If you remember anything from this article, make it these key points.
- Risk management in forex trading should be at the forefront of your forex trading strategy. Always think about preventing losses before making profits!
- Leverage is super risky. Sure, it may be a great way to trade with a lot more than you have, but your broker always gets paid, even when you lose!
- Diversifying your portfolio and knowing your risk-reward ratio is vital. Don’t put all your eggs in one basket and know how much you are willing to lose for certain opportunities.
- Without a forex risk management strategy in place, you’re basically gambling! You have no control over your risk, and it can become very easy to lose it all.
Learn more about risk management in forex trading with our forex trading course
Want to learn more about forex and how to trade? Then sign up to our forex trading course!
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