The proper entry leads to big profits, while the poor entry can lead to severe losses,” is a common saying among professional traders. This is correct, and it is for this reason that risk management in forex trading is critical to becoming a successful forex trader.
Every risk management rule aims to preserve trade capital, but this does not rule out the possibility of losses. It is unavoidable for a forex trader to lose money at some point. Risk management, on the other hand, mitigates these losses so that they do not cause you emotional or bodily distress.
It’s vital to remember that a good FX trader isn’t one who wins more transactions than he loses, but rather one who makes more money winning than he loses. Risk management is the foundation of any successful trading experience, and the sooner you learn to control your risks, the less likely you are to suffer losses that wipe out a large portion of your capital.
So, how do you control your forex trading risks?
The Rules to Managing Risks in Forex Trading
Many aspiring FX traders have been left without funds due to poor risk management. This, however, can be avoided, and we’ve outlined several guidelines that should serve as your guide as you seek to control risk in forex trading.
Rule 1: Do Not Trade With Important Money
The first error made by forex traders, especially newcomers, is that they desire to make money as quickly as possible. This leads them to risk all of their money, regardless of its value, and their career as a forex trader is cut short owing to a series of poor judgments.
This is the most important rule for all traders. Do not trade with large sums of money. Never expect that your transaction will go smoothly. In reality, you should always expect your trade to fail. Assume you’re a gambler at a casino.
Do you risk your entire fortune on black chips with every dime you have? The same is true when it comes to Forex trading.
When you trade with important money, you risk losing all of your money. Because these funds are important, there would be an unhealthy pressure to earn them back, resulting in financial, physical, and emotional stress. This would impair your ability to make wise decisions, increasing the chances of making a mistake.
It’s crucial to keep in mind that the foreign currency markets are prone to volatility. As a result, trading aggressively rather than conservatively will result in you counting losses rather than earnings.
Losing money while trading is unavoidable. To balance the risk-to-reward ratio in forex, be cautious with your trades and avoid trading with large sums of money.
Rule 2: Determine the Kind of Risks You Can Take
Determining the type of risk you can take is another technique to control hazards in forex trading. A person who isn’t clear about what he wants will be forced to accept whatever is offered.
As a result, before you trade with money you don’t need, think about how much risk you’re willing to take. The steps below will help you find your answer quickly. Please respond to the following questions.
- First, determine your age. Can you make decisions on your own? Are you an adult?
- Second, how confident are you about forex trading? Are you quite knowledgeable to navigate the volatile market yourself?
- Third, how many years have you been a forex trader? Have you taken up projects that gave you insight into risk-taking?
- Fourth, how much can you lose comfortably without breaking a sweat? What’s the height of any loss for you?
- Lastly, what are your investment goals? What do you seek to achieve?
You can keep control of the situation when trading if you can determine the types of risks that are acceptable. It distinguishes you from another trader who is anxious about a deal since you know you are in charge and that if things go wrong, the amount you traded won’t bring you back to square one.
Essentially, selecting the types of risks you can take safeguards you financially, emotionally, and physically. It also increases your chances of making a profitable trade.
Rule 3: Stop-Limit Orders and Stop-Loss Orders
When we talk about orders, we’re talking about trade placement instructions that you give to your broker. These orders are triggered when the market price exceeds a specified point.
These are conditional trade orders. These orders normally have a set time frame and combine the elements of a stop order and a limit order to minimize the risk associated with trading. Limit orders, which entail buying and selling shares for a fixed price or a better price, and Stop-on-quote orders, which involve buying and selling stocks after the amount has passed a fixed price, are comparable to stop-limit orders.
These orders are instructions given to a broker. It involves the buying and selling of certain stocks after the said stocks have surpassed a fixed price. This gives you protection as a trader against loss. If you set your stop-loss order to 5% lower than the price spent when you purchased the stocks, this will restrict the loss you’ll accrue to just 5%.
Let’s use a more practical example. Imagine you bought Amazon shares at 10 dollars per share and as soon as you made the purchase, you set the stop-loss order at 9 dollars. In the case that stocks fall below 9 dollars, your shares will be sold at the existing price.
Why are these orders important?
- They protect you against loss
- You can be in optimal health without being troubled and stressed about the market because you are protected
- It keeps your trading plans in check
Rule 4: Risk to Reward Ratio (RRR)
Having sufficient knowledge about your risk and reward ratio betters your chances of making a profit as you move in your trading journey. The risk to reward ratio calculates the difference between your orders and your entry point.
It is important as traders to maintain a risk to reward ratio of at least 1:2 and some have advised that the ideal risk to reward ratio should be 1:3. That is, if you are risking $1, you should be earning $3 or more.
Rule 5: Have a Risk Pattern
The temptation to pour more money into trading as soon as profit is made can be quite high. However, it is most times a setup for destruction. This action is prevalent amongst newbies who increase their trading position as soon as they make a significant profit.
It is important to maintain a risk pattern. Do not be too confident and never think that because you had a favorable trade week, the next would be better. It could turn out worse. Changing risk patterns involves the alternation of rules that helped you in managing risks during your successful trade and this flexibility might lead to a complete wipeout of your accounts.
As long as you have a plan that has worked for you as a trader, a plan that mitigated risks and brought profits, it is important to stick to such risk patterns and follow the plan regardless of the desire to earn more.
Rule 6: Determine The Level Of Risk Allowable Per Trade
You need to realize that the risk you take per trade is a fraction of your capital and thus, without determining the level of risk allowable per trade, you set yourself for failure in the long run. This rule is crucial for beginners who are more prone to mistakes than veterans in the market.
Make it a standing rule to only lose a little percent of your capital for each trade. To start with, set the risk percentage at 1% of your total capital. Using the risks to reward ratio explained earlier, this means that for that 1% risk, a profit of 2% or 3% should most likely be earned.
Look at the example below.
Mr. A, B, and C determined their risk levels as 1%, 3%, and 8% of their capital respectively. They all had a capital of $150,000 and had 20 losing streaks. This means that Mr. A has lost about 20% of his capital. Mr. B has lost about 50% of his capital and Mr. C has lost above 85% of his capital.
Basically, once you don’t determine your risk levels, it makes it almost impossible to recover from losing streaks which all traders are bound to experience at one time or another in their journey as traders.
Rule 7: Consider Currency Correlations
To begin, you must recognize that currencies are related and that recognizing currency correlations will lower your risk level. These correlations describe how the price of one asset changes in proportion to the price of another.
When two currencies have positive correlations, they will move in the same direction, whereas when they have negative correlations, they will move in opposing ways.
It has always been man’s innate nature to take risks. However, while taking risks can change your life for good, it can also be your angel of death. Hence, managing your risk factor while trading isn’t just key. Rather, it is the key to a successful trading experience.