6.1 The basics of risk management
Risk management is a crucial skill in any trader or investor’s toolkit. It revolves around scanning for factors that can have negative effects on trades, and reducing their impact as thoroughly as possible.
Proper risk management is the fundamental distinction between trading and gambling. While investing and trading inherently involve carry a degree of risk, the recognition and effective management of these risks distinguish a successful trader from someone who merely gambles on speculative trades.
6.2 How does risk management in forex work?
In forex trading, risk management is performed by setting a series of rules and actions that protects against the downside of a trade.
However, the idea is not to avoid risk altogether. Instead, the aim is to minimise risks while maximising potential returns.
But how do you manage your risk if you don’t know what they are, or where they could come from?
That’s an excellent question, and points to the crux of the matter – risk management is about understanding what you are doing, the likely consequences of your choices, and what to do (and not do) in order to maximise the chances of a favourable outcome.
6.3 What risks should forex traders look out for?
Liquidity is a measurement of how easily you are able to enter and exit a forex trade; this is determined in part by how widely a currency pair is traded.
Not all currency pairs have equal levels of liquidity, instead popular currency pairs such as EUR/USD have higher liquidity than minor pairs and exotics such as GBP/JPY or USD/SGD.
Pairs with low liquidity may face high spreads (the difference in prices set by the seller and the buyer) which can eat into profits
, or deepen losses.
Orders may also face delays in being filed which may result in a worsening of the result of your trade. In dire cases, currencies may even be unavailable for trade.
Check out a more in-depth article on market liquidity.
This is related to the capabilities and technology of the brokerage platform you use. Broker risk ranges from the quality of the trading software provided, to connection stability and speed, and anti-fraud and account safety measures.
For this reason, it’s important to pick a reliable and trustworthy brokerage.
Market risk refers to the volatility of the forex market, which can be affected by a number of events. Some examples are political instability or upheavals (such as unexpected election results), economic issues such as recession or interest rate spikes, or international relations, such as trade tariffs or wars.
Country social risk
Given that currencies are intricately linked to the countries that issue them, it’s crucial to focus on the nation’s overall situation, encompassing aspects like political, financial and social stability.
Country risk stems from trading a specific currency in a specific country, which may come with inherent conditions or restrictions that could affect your trades.
Social risk can arise when a country’s social stability is challenged due to uprisings, demonstrations, and civil wars – events that could have unfavourable effects on its currency.
6.4 How forex traders can manage risks
Proper use of leverage
In simple terms, leverage means borrowing from the broker to trade a larger position in a currency. This can multiply the returns on a winning trade; but on the flipside, losses are similarly amplified.
For instance, in a 100:1 leveraged trade, you need only put down \$1,000 to trade \$100,000 – which is the standard lot size.
Recall that a pip is the last number in the forex price, which is usually quoted out to 4 decimal places (0.0001). This means that in this situation, a one pip loss is equal to (100,000 x 0.0001), or $10.
Also, assuming that instead of 1 standard lot (100,000 units) you decided to trade 10 mini-lots of 10,000 units each. If you make a loss of 50 pips across all 10 trades, how much would your total loss be?
Well, 1 pip = \$10, so 50 pips = \$10 x 50 = $500.
In contrast, if you didn’t trade with 100:1 leverage and instead opted for trading a micro-lot of 1,000 units, the scenario changes. In this case, where one pip loss is equal to (1,000 x 0.001) or \$1, a loss of 50 pips would result in a \$50 loss.
Of course, the flipside is also true – if the trade was profitable, with leverage you would gain \$500 in profits; without leverage, just \$50.
As you can see, leverage is a powerful tool but like a double-edged sword, it can cut both ways. Hence forex traders must choose an appropriate level of leverage, and always be clear about the potential loss they face should the trade go against them.
Proper allocation of trades
Another essential risk management technique is making sure to choose proper allocation of trades.
What this means is that the capital at risk for each trade you make should not exceed a certain percentage of your overall capital – before leverage. A good rule of thumb is 3%, but you may wish to go higher or lower depending on your own risk profile.
For instance, let’s say you have a trading capital of \$20,000, the capital at risk committed to each trade should not exceed (\$20,000 x 3%) = $600.
Setting stop losses
A stop loss is a trigger point at which your trade is automatically closed, taking any loss or profit at that point.
This is a simple yet powerful way to manage your risk as it prevents you from giving in to negative emotions such as greed, which may cause you to stay in a losing trade and end up with more losses.
As stop losses are decided ahead of time – you choose the price level at which the stop loss will trigger – they are ideal for keeping you on track. They can also help save your trade from unexpected market movements that occurred while you were unable to respond, such as overnight.
Note that stop losses are not 100% foolproof. During moments of extreme volatility, your stop-loss order may fail to be filled by the market, which means your position will remain open.
Nevertheless, stop losses are highly useful and traders should familiarise themselves with their use.
Another often-overlooked yet essential skill is knowing when to take profits. This means being able to discern the most appropriate time to close a profitable trade so as to lock in your profits in your account.
While it can be tempting to ride a profitable trade all the way to the end, the speed at which the forex market moves can make this easier said than done.
Just like with stop losses, you can set a take profit order to help you automate your profit taking and better manage your trades.
6.5 Understanding Risk-reward Ratio
An essential concept to master in forex trading (and trading in general) is the risk-reward ratio.
Of course, different risk-reward ratios have different probabilities of success; a ratio of 1:2 happens far more often on average than a ratio of 1:10.
Another thing to note is that risk-reward ratios are not set in stone. Rather what i
’s considered an appropriate ratio depends on timeframe, trading environment, entry and exit points and trading strategy used.
You can calculate your own risk-reward ratio by using the following formula:
- R/R Ratio = (Entry Point – Stop Loss Point) / (Profit Target – Entry Point)
Learn more about calculating lot sizes, pips and risk to reward here: https://www.vantagemarkets.io/academy/calculate-lot-sizing-pips-risk-to-reward-in-forex/
6.6 The Importance of a Trading Plan
We’ve gone through many different aspects of risk management in this module. How do you bring it all together and keep track of it all? That’s where a trading plan comes in.
A trading plan is a codified set of rules and decisions you lay down for yourself as a template to guide your trading journey. Think of it as a systematic method for identifying trading opportunities.
A trading plan contains a basis for making trading decisions based on proper research, and taking into account various factors such as time, risk profile, market sentiment and investor objective.
This is an important tool that will help keep you on track with your goals and stick to trades with a sound foundation.
Additionally, consider expanding your trading plan to include a record of your trading experiences, learnings and outcomes – a sort of trading plan/journal hybrid, if you will.
This way, your training plan can evolve along with you, as you learn new skills, develop trading strategies, and formulate and test new trading strategies. When you find that your previous assumptions no longer hold, you may update the trading plan with your new findings.
A trading plan is also a great way to build discipline and learn from your experiences. You should detail each trade you make, including important information such as entry and exit price, capital at risk, profit or loss and return on investment.
Finally, your trading plan or journal will only be valuable to the extent that you make use of it. Please make sure not to overlook updating your trading plan even if you start gaining confidence as a trader.
- Risk management is an essential skill that forex traders must master. It involves scanning for factors that may negatively affect trades and taking steps to minimise their impact.
- The crux is to minimise risk while maximising the potential for returns.
- Proper risk management is what sets a professional trader apart from someone who simply gambles on the forex market.
- Liquidity risk arises when a currency pair has low trading volume. This can cause high spreads, or even prevent trades from being executed altogether.
- Broker risk depends on the technology, capabilities, policies, and safety measures of the brokerage you choose.
- Market risk refers to the volatility of the market and can be impacted by economic or political issues.
- Traders should also be aware of country and social risks that may be at play in the countries whose currencies they are trading.
- To manage risk, proper use of leverage is crucial. Be aware that leverage multiples your potential loss, which may outstrip your account value.
- Properly allocating trade positions is also important. As a general rule, never risk more than 3% of your real trading capital in any one trade, although exceptions may apply.
- Learn how to set stop losses to reduce potential losses and improve your trading outcomes.
- Taking profit at appropriate levels can give you better results over the long run versus attempting to ride out every trade.
- Understanding risk-reward ratio is crucial to your success. Risk-reward ratio varies from trade to trade, and you can calculate your own ratio for each trade.
- A trading plan is an integral tool for risk management. It serves as a record of your trading outcomes, helps you to learn from past mistakes, and may help detect unconscious biases or negative beliefs that are hindering your success.