Risk Management In Forex Trading
This article is all about risk management in Forex trading.
Risk management is one of the most important aspects to apply in your trading. How you manage risk can also make all the difference to your results.
Most traders spend a lot of their time looking for the best entry signals. They want to know when to buy and sell and what indicators will help them achieve a higher success rate.
That is all well and good but trading strategies with high success rates doesn’t necessarily mean that they will be consistently profitable.
In fact, it is possible for a trading strategy with a low success rate to be profitable.
It is a combination of both your success rate and your average win and loss that will determine your success or failure in the markets.
Keep reading to find out why and how risk management in Forex trading is the key to success.
As well as to receive 15 tips you can apply to better manage risk.
What is risk management in Forex trading?
Risk management in Forex trading is simply the process of minimizing the risk of loss and maximizing the opportunity to profit.
This is the bird’s eye view of the subject but there are many different principles, techniques and tactics traders use to try and achieve this.
Let’s take a look at some of the most common ways a trader can apply risk management in Forex trading.
15 tips for better risk management in Forex trading
These are presented in no particular order;
Tip 1. Have a trading plan
The purpose of having a trading plan is to help you trade in a methodical, systematic and consistent way.
A trading plan should include what you are going to trade, your trade execution criteria and how you are going to manage risk.
You should know in advance what events you are looking for to occur in the market before executing any deal.
A trading plan will also help you to refrain from making decisions on whim or in an emotional state in the heat of the moment.
This is what separates those that are trading as a business and those that are just gambling in the markets.
With that being said, the most important part of your trading plan is in its implementation.
Plan your trade and trade your plan. The rules you don’t follow don’t matter.
Tip 2. Practice on a demo account
Before trading with real money, it would be a good idea to practice in a risk free environment on a demo account.
This will help you to test ideas, eliminate operational mistakes and allow you to become more familiar with price behavior and patterns and trading in the markets.
Just know that there is a psychological difference between trading on a demo and a live account.
Trading on a demo account will help you to get ready to move on to a live trading environment.
However, it will only teach you so much and at some point the psychological gap between trading with virtual and real money must be bridged.
This is usually a big gap for most people so the real learning will start when you have some skin in the game.
Practice is the mother of all skills.
Tip 3. Only trade with money you can afford to lose
Learning how to trade Forex involves time, effort and money.
It is not uncommon for traders to lose most of the money in their trading accounts when they are just getting started. Actually, this is probably the norm.
I am just saying this to give you realistic expectations and to inform you that you will make mistakes in order to gain experience. This is all good because they are opportunities to learn.
The best lessons are the ones that you learn by yourself and cost you money.
Losing trades are a natural and inevitable part of trading and all successful traders have paid some form of tuition fee to the market. This is how you should view losing trades, tuition fees and costs of doing business.
It would be a good idea to start with an amount you are comfortable with, that will also limit the risk of loss but allow you to take trading seriously.
You can start small then scale up when you have experience and a track record of performance.
Never trade with money you cannot afford to lose.
Tip 4. Make capital preservation your priority
You will encounter a string of losing trades from time to time.
But, the financial loss should never be enough to completely put you out of business.
So protect your capital first and try to make it grow second. The objective here is to keep draw downs to a minimum.
Take calculated risks and only trade when the odds are stacked in your favor.
Tip 5. Trade with an appropriate lot size
One of the primary reasons why traders lose money in the Forex market is because they trade lot sizes that are just too large relative to their account balance.
There are many different ways you can apply risk management in trading. But one simple thing you can do is to only risk a small percentage of your account balance on any single trade idea.
By only risking a small percentage of your account balance, this will help minimize losses and allow you to survive in the market to trade another day
Typically, 1% to 3% risk is used by most traders but ultimately this can depend on the success rate of a trading system and the trader’s tolerance to risk.
The more trades you have in reserve to recover from a losing streak the better.
Tip 6. Be consistent with your lot size
Apart from trading lot sizes that are too large relative to your account balance.
Switching between large and small lot sizes from one trade to the next can have a detrimental effect on your overall performance.
Reducing your lot size when in a draw down is a feasible risk management strategy. So is scaling up and trading larger lot sizes as your account balance grows.
However, these are best done strategically. Such as when your account balance reaches a 20% draw down or growth respectively, just to give you an example.
Changing lot sizes from one trade to the next can undo weeks of positive performance quickly and easily or limit further growth.
Be consistent with your risk management in trading and reassess it at predetermined milestones.
Tip 7. Diversify for better risk management in Forex trading
Forex trading and investing involves uncertainty and this is why diversification can be a sound risk management strategy.
Diversifying basically means trading or investing in multiple uncorrelated currency pairs at the same time.
The goal of diversification is to create a balanced portfolio of assets that don’t have a strong positive or negative correlation in price performance.
Some trade ideas will work out some of the time while others will not. Diversifying can help spread the risk and compensate for those losing trades.
Don’t put all your eggs in one basket.
Tip 8. Hedge your position
Hedging is another concept used for risk management in trading or investing.
Unlike diversification, hedging involves trading in more correlated currency pairs. It is also possible in some jurisdictions to trade both long and short the same currency pair at the same time.
The goal of hedging is to limit the risk of loss by taking an equal and opposite trade in the same or another highly correlated currency pair or asset class.
When one trade moves further in to a losing position, the other trade can move further in to a profitable position.
If the entries and exits of a hedged position are timed correctly, it is possible to profit from one or both of them.
Tip 9. Don’t over expose your account balance
Risking a small percentage of your account balance and diversifying are sound risk management strategies.
Using them together without restriction though can increase risk though. Therefore, limiting the number of open trades allowed at any one time is prudent risk management in trading.
This will allow you to potentially benefit from both principles while simultaneously keeping the real risk of loss to a predefined minimum.
Trade in moderation.
Tip 10. Know when not to trade
Just because you have opened up your trading platform to trade does not mean that you should be trading.
You should know in advance what signals you are looking for to execute any deals. When they aren’t present you should refrain from trading.
It is not enough to know how to make money trading to be a successful trader. You must also know what leads to losses in the market and avoid engaging in those activities.
Some of which includes revenge trading, chasing price for fear of missing out and generally just being proactive in the market. Trading should be a reactive activity, so don’t force trades for actions sake.
After a winning or losing trade, it can be a good idea to withdraw your attention from the market and stand aside for some time. This will reduce the likelihood of giving money back unnecessarily or exaggerating losses.
When in doubt, stay out and let the opportunities come to you.
Tip 11. Give adequate room for your deal to breathe
Ideally, you should optimize your entries and exits when trading so you can get the best price and be in at the most opportune time.
The best scenarios you could aspire to achieve are for the price to move in your favor immediately after executing a deal. Then move quickly towards your take profit with minimal price corrections in between.
Although this can happen sometimes, it is very probable that price will move against your prediction for some of the time.
This is why you need to place a stop loss and account for a margin of error.
Sometimes it just takes time for a deal to play out as predicted but other times, the trade just won’t work out.
Your stop loss should be placed at a price that would invalidate the reasons for taking the trade and get you out of the market.
Tighter stop losses that are closer to the current market price are more likely to get hit. Wider stop losses that are further away from the current market price are less likely to get hit.
Adjust your lot size accordingly.
Tip 12. Close losing trades quickly
One other reason why traders consistently lose money trading forex is because they let losing trades run.
They let small losses turn in to bigger one by either increasing their stop loss or trading without one. Then not accepting a loss the loss when to time comes.
It becomes psychologically more difficult to accept a larger loss when you could have taken a smaller one earlier. Hanging on to losing trades can create an emotional downward spiral, hoping that the price will come back.
Sometimes it does, but the culmination of consistently trading like this is almost always costly.
All businesses can improve their profit margins by minimizing losses and reducing costs. Trading Forex is no different.
This tip is an elementary lesson in risk management in Forex trading.
Learn to accept your losses quickly; don’t let a losing trade run and turn in to a bigger loss.
Tip 13. Trade in the direction of the dominant price trend
Prices move in waves,
To stick with this analogy, these waves can be further classified as a tide, a wave or a ripple. Together they make up price trends.
The tide can be seen more easily on the higher time frames. The corrective and counter trend waves and ripples can be found and seen more easily on the lower ones.
Everything is relative to the time frame you are trading.
To improve your probabilities of success, wait for the ripples and waves to turn in the direction of the major tide or current. Enter in anticipation that the major trend will continue.
Counter trend trading is more risky and more tiring.
The trend is your friend.
Tip 14. Trade on higher time frames
Trading on the higher time frames, like the daily and 4H charts can provide more obvious and reliable trading signals.
This will also help you to filter out the noise and false signals that are more prevalent on lower time frames.
Trading less often can be a whole lot more.
Tip 15. Scale in and out of positions
Scaling in and out of positions is another way traders can better control their risk management in trading.
This technique works by splitting your overall trade up in to several smaller trades and buying multiple times to build a position. It is wiser to average up and buy less volume at higher prices than to average down.
Buying a smaller amount initially, then buying more later on as the market shows that you have a good trade idea can help minimize risk.
If your initial trade idea wasn’t a good one, the loss will be lower than what it would be by entered with your full position at once.
The same principle applies for scaling out of positions.
As the price moves in your favor, you can close portions of your position at incrementally higher prices. The benefit of doing this allows you to take something off the table to minimize the risk of a trend reversal and taking your profits away.
There are positives and negatives with this approach. Although scaling in to positions can minimize risk, scaling out of positions can minimize the potential to profit too.
Whether you choose to scale in and out or be fully in and fully out of your trades, try and be consistent with your approach.
Final thoughts about risk management in Forex trading
Accepting and embracing risk in Forex trading is something that all traders must do.
It is not possible to entirely eliminate risk and expect to make money in the Forex markets.
Wherever the potential exists to make money, there will always be some kind of risk involved. This is true for any endeavor, whether you are an employee or a business owner.
You should treat your trading as a business and this involves having a plan that includes ways to manage risk.
How you do this is up to you, and many of the tips outlined above will give you something to think about and help you achieve that.
You can apply some or all of these tips but others are mandatory if you want to achieve consistent and long term success trading.