Why do you need to use risk management strategies?
It’s not uncommon for beginner Forex traders to think that making money through online Forex trading is fast and easy. However, it’s a process that takes time, dedication, commitment, and patience, if you want to be successful and profitable in the Forex market in the long run.
You can’t just open a position in your trading platform without taking into account the trading conditions set by your Forex broker, the currency risk, and the trading risk that can affect your invested capital. You also need to apply tools and techniques to manage your money and risks – if you don’t do those things, you wouldn’t be trading – you’d be gambling.
We’ve gathered here, seven basic Forex risk management tips you need to know to be successful in the currency market.
#1 Only invest money you don’t need
It might sound obvious, but the first rule in currency trading, or any other kind of trading for that matter, is to only risk the money you can afford to lose. Many traders, especially beginners, skip this rule because they assume that it “won’t happen to them”.
If trading were like gambling at a Casino, you wouldn’t take all the money you have to the Casino to bet on black, right? Well, it’s the same with trading – don’t take unnecessary risks by using money you need to live.
Firstly because it’s possible to lose all your trading capital, and secondly, because trading with funds you live on will add extra pressure and emotional stress to your trading, compromising your decision making abilities and increasing the chances of making mistakes.
The Foreign Exchange market is a very volatile and unpredictable market, so it’s better to trade “conservative amounts” from your disposable income.
#2 Think about your risk tolerance
Before you start trading, you need to determine your risk tolerance, depending on:
- Your age
- Your knowledge of FX trading
- Your experience
- How much you’re willing to lose
- And your investment goals
Knowing your risk tolerance is not just about helping you sleep better at night, or stress less about currency fluctuations.
It’s about knowing you are in control of the situation, because you’re investing the right amount of money vis-à-vis your personal financial situation in relation to your financial objectives.
Keep your investing within your risk tolerance and you decrease the likelihood of trading ruin.
#3 Set your risk/reward ratio to a minimum of 1:3
Knowing about risk/reward ratio (RRR) will definitely improve your chances of becoming profitable in the long run, setting limit orders (stop-loss and take-profit) that protect your capital.
A RRR measures and compares the distance between your entry point and your stop-loss and take-profit orders.
For example: Let’s say that you’re investing on the EUR/USD. If the distance between your entry level and your stop-loss is 50 pips, and the distance between your entry point and your take-profit is 150 pips, then you would be using a RRR of 1:3, because you’re risking 50 pips to earn 150 pips (150/50 = 3).
Read: What are pips?
The risk/reward ratio is a necessary tool to set your stop-loss and take-profit orders depending on your risk tolerance, and every wise trader should control the downside risk.
Even though determining a RRR depends on each trader’s risk tolerance, it’s common to use a risk/reward ratio of 1:3, where you expect to earn 3 times what you’re willing to lose.
4# Control your risk per trade
When thinking about risks, you also need to consider your trading capital.
You should only invest a small portion of your trading capital per trade: a good starting point would be to not invest more than 2% of your available capital per trade.
If you have $10,000 in your Forex trading account, the maximum loss allowable would be $200 per trade.
Determining the risk per trade is a helpful tool if you go through a losing streak, so then you can better protect your trading capital, and avoid large drawdowns in your trading account.
#5 Keep your risk consistent
Most beginners will increase the size of their positions as soon as they’re making profits, which is one of the best ways to get your account wiped out. Keep your risk consistent!
Just because you’ve made a few winning trades doesn’t mean that the next one is going to be profitable.
Do not become over-confident and less risk-averse, as that will lead to you changing your money and risk management rules without solid reasons.
When you worked on your trading plan, you had to set up rules to decide about an effective size for your positions. This is just one step in establishing a successful trading method, now you need to stick to and follow your investment plan!
#6 Understand and control leverage
The Forex market is a leveraged market, because of its high liquidity. Leverage means that you can invest more money than your initial deposit, thanks to margin trading. Your broker will only ask you to put aside a small portion of the total value of the position you want to open as collateral.
When using leverage, your profits can be magnified quickly, but remember that the same applies to your losses. This is why you need to understand how leverage and margin trading work, as well as how they impact your overall performance and trading.
Forex traders are often tempted to use high leverage to make significant profits, but if you’re over-leveraged one quick change in the market could easily wipe you out.
Note: In August 2018, the European Securities and Markets Authority (ESMA) imposed limitations on the leverage offered by brokers. These leverage limits on the opening positions by retail investors vary depending on the underlying:
- 30:1 for major currency pairs
- and 20:1 for non-major currency pairs
7# Take currency correlations into consideration
Because currencies are priced in pairs, it’s important to understand that currencies are linked to each other, or correlated. Knowing about Forex correlations will help you better control your Forex portfolio’s exposure by reducing the overall risks. Go here to find out the 16 most popular currency pairs.
Correlation represents a measure of how one asset evolves in relation to another. If two assets are positively correlated, it means that they tend to evolve in the same direction, while if they are negatively correlated, they will evolve in opposite directions.
To use FX correlations to your advantage, you need to remember a few things:
- Avoid opening several positions that cancel out each other
For instance, if you go long on the EUR/USD and the USD/CHF, you can expect both currency pairs to evolve in opposite directions, which is almost like having no trading position in your account.
Because the USD is used once as a base currency (USD/CHF), and once as the quote currency (EUR/USD), which means that if the USD strengthens against its major counterparts, then the EUR/USD will go down, while the USD/CHD will go up – the evolution of one exchange rate cancelling out the other one.
- Avoid opening positions with the same base currency, or quote currency
For instance, if you go long on the EUR/USD, the AUD/USD, and the GBP/USD, you can expect these currency pairs to be positively correlated because they all have the same quote currency, the USD.
It means that when the USD strengthens/weakens, your portfolio will go up/down.
- Avoid opening several positions that cancel out each other
- Be aware of commodity currencies
Commodity currencies represent currencies that move in accordance with commodity prices, because the countries they represent are heavily-dependant on the export of these commodities.
As a general rule, if the price of commodities strengthen, then the currencies of the commodity producers will go up – and vice-versa.
The main correlations to know about are the Canadian Dollar (CAD) and oil, the Australian Dollar (AUD) and gold/iron core, as well as the New-Zealand Dollar (NZD) and wool and dairy products.
- Be aware of commodity currencies
To improve your Forex trading performance, you should understand your exposure: some currency pairs move together, while others evolve in opposite directions. The key is to diversify your portfolio to mitigate risks.
These tips are just the cornerstone to better manage your risk – as you research further, you’ll find other Forex trading tools and techniques for beginners you can use to improve your trading strategy.
Before using a live trading account, try to back-test your trading plan on a demo account, and improve your strategy if needed. Review your trades on a regular basis with a trading journal that will help you understand what you did right, and what you can improve. Learn from your mistakes, and accept responsibility for losses.
Regardless of the timeframes you use, whether you rely on technical analysis or fundamental analysis, always follow your trading plan. Control your emotions and be patient enough to wait for your trade setups to be confirmed before opening/closing a position.
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CHAPTER QUICK LINKS
- 2.Why is Forex Popular?
- 3.Why Forex is (or isn’t) for You
- 4.How Does Forex Work?
- 5.Popular Traded Currencies
- 6.History of Forex Market
- 7.FX cash, CFD or Spread Bet?
- 8.How Margin Trading Works
- 9.Best Time of Day to Trade
- 10.Forex Regulation And Protection
- 11.Forex Trading Examples
- 12.Making a Living Trading Forex
- 13.Mind, Money, Method
- 15.Winning Forex Strategies
- 16.Technical vs. Fundamental Analysis
- 17.New Forex Trader Mistakes
- 18.Dangers of Forex Trading
- 19.Next steps