This post contains a list of 15 top risk management tips you can apply to your trading.
Most traders’ time and attention is spent 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.
Although that is all well and good, this is just a small part of trading. A high success rate alone doesn’t necessarily mean that you will be a consistently profitable trader.
The key to success in trading is risk management and how you go about doing that can make all the difference to your trading results.
So keep watching to find out why and how risk management in forex trading is the key to success.
I will also do my best to provide the information in an easy to understand way.
So without any further delay, let gets straight in to it.
What is risk management in 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 traders apply risk management in forex trading.
These are presented in no particular order;
Risk management tips for trading
1. Create a trading plan
The purpose of creating a trading plan is to help you trade in a methodical, systematic and consistent way. You should know in advance what events or patterns must occur in the marketplace in order for you to execute a trade.
When you trade on a whim, or in an emotional state, you will be susceptible to making trading mistakes. This invariably results in losing money in the markets.
Successful traders back test their strategies; develop their edge and trade when the probabilities are stacked in their favour. This is what separates those that are trading as a business and those that are just gambling in the markets.
Just keep things simple, you can compile a checklist to include your trade entry and exit criteria, what you are going to trade and how you are going to manage the money in your trading account.
With that being said, the most important part of your trading plan is the implementation.
The rules you don’t follow don’t matter. Plan you trade and trade your plan to help you limit and manage risk.
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 eliminate operational mistakes, test ideas or strategies and allow you to become more familiar with trading in the markets.
A demo can help you to learn how to manage risk but it does have its limitations.
You don’t have any skin in the game.
The difference between demo and live trading is all psychological. The emotions of fear and greed are absent with the former and more amplified with the latter. When you have some skin in the game, the emotions I just mentioned become huge motivators that can work to your detriment.
This is why having a plan to help you manage this risk is so important.
But at some point, the psychological gap between trading with virtual and real money must be bridged.
The good thing about trading with TIO Markets is you can practice on a demo account and then start trading from as little as $50.
Trading is very affordable and you can start with an amount you are comfortable with.
Practice is the mother of all skill.
3. Only trade with money you can afford to lose
Learning how to trade Forex involves time, effort and money.
It is important to have realistic expectations when starting out and to allocate some funds for your educational purposes.
You must be prepared to invest in yourself and your education if you want to succeed in trading.
But, unlike pursuing other vocations, you don’t necessarily need to spend money on a course to learn how to trade. Although that might help, it isn’t really necessary as there is plenty of content freely available online to learn from.
And neither is really enough though, trading is a skill that is acquired by doing and experience is the best teacher. In the most part of gaining experience, it will involve making mistakes.
In trading the best lessons are the ones you learn by yourself and cost you money.
Losing trades are a natural and inevitable part of trading and you should view losing trades as tuition fees and costs of doing business.
All successful traders have paid some form of tuition to the market to learn how to trade.
So; It would be a good idea to start with an amount you are comfortable with, but still allow you to take trading seriously. Never trade with money you cannot afford to lose.
4. Make capital preservation your priority
You will encounter a string of losing trades from time to time.
That’s trading 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 and refrain from over trading.
You can’t trade when you run out of money.
Take calculated risks and only trade when the odds are stacked in your favor.
5. Don’t over leverage your account
One of the primary reasons why traders lose money when trading is because they trade with lot sizes that are just too large relative to their account balance. Consequently, using high amounts of leverage.
There are many different ways you can apply risk management in trading.
One simple thing you can do is to only risk a small percentage of your account balance on any single trade idea.
Typically, 1% to 3% risk is used by most traders but ultimately this can depend on the success rate of your trading system and your tolerance to risk.
If your trading system has a high success rate, you can risk a little more. If your trading system has a lower success rate, you should risk less.
By only risking a small percentage of your account balance, this will help minimize losses and preserve capital so you can continue to trade. So consider capitalizing your account adequately enough to give yourself the flexibility to better manage risk.
6. Trade consistent lot sizes
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. Since you are trading based on a probabilistic outcome, there is always a chance that the next trade will not work out.
And you don’t really know when that will be. So going from trading 0.1 lots to trading one lot can potentially undo weeks or months of progress in a single trade quite quickly.
Rather than making sudden or drastic changes to your lot size from one trade to the next. Scale up or down in smaller increments to better manage the risk.
Here are two scenarios when you might want to consider doing this.
The first scenario is when you are trading well and your account balance is growing. Consider scaling up your lot size to compound your growth.
The second scenario is when you are going through a losing streak and your account balance is in a state of draw down. Here, you can consider scaling your lot size back to reduce the risk of further loss. Adjusting your lot size is best done strategically. So be consistent with your lot size and reassess any changes at predetermined milestones for better risk management.
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.
When trading, some of your trade ideas will work out while others will not. But Diversifying in to different assets or currency pairs can help spread the risk and compensate for those losing trades.
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.
This is a good way to manage risk but don’t get carried away with this without considering some of the other tips I am going to mention.
But there is an old adage you might have heard before that expresses this tip quite well.
That is, don’t put all your eggs in one basket.
8. Hedge your position
Hedging is another concept used for risk management in trading or investing. And 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 opposite trade in the same or another highly correlated currency pair or asset class.
So the affect this has is when one trade moves further in to a losing position, the other trade can move further in to a profitable position. The result is to offset losses.
If the entries and exits of a hedged position are timed correctly, it is possible to profit from one or both of them.
Approach this risk management strategy with caution. Novice traders can easily get stuck holding on to losing hedged positions.
Sometimes it is better to take a quick small loss, rather than holding on and trying to trade your way out of it.
This leads me nicely into the next tip.
9. Close losing trade quickly
Another major reason why traders lose money when trading is because they let losing trades run.
A small loss is allowed turn in to a bigger one, either by moving the stop loss further away or trading without one. Either way, this trading behaviour comes from a place of unwillingness to accept a loss.
The problem with this is that it then becomes psychologically more difficult to accept a larger loss. And hanging on can create an emotional attachment to the trade. It is a downward spiral, hoping that the price will come back to get out, at least at break even.
That might happen but if you find yourself in this situation, you are assuming risk without any potential for reward. This way of trading probably won’t work out favourably in the long term. You are just one trade away from blowing your account.
Trading, like any other business, involves risk, and losses cannot be entirely eliminated. However, Profit margins can be increased by minimizing waste, reducing costs and making better informed decisions.
So you should learn to accept the risk and take your losses quickly; don’t let a losing trade run and turn in to a bigger one. This is an elementary tip for better risk management and it is highly compatible with the next one.
10. Don’t over expose your account
Cutting losing trades quickly and risking a small percentage of your account balance are sound risk management strategies.
Therefore, it is wise to limit each trade and the number of open trades you have to protect your account against significant equity draw downs.
This is simple to implement, and as an example, you might decide to risk 1% of your account per trade with a maximum of 5 trades open at any one time.
This will allow you to potentially benefit from both principles while simultaneously keeping the real risk of loss predefined and manageable.
11. Know when not to trade
This one comes from experience or having a well thought out trading plan.
You should know in advance what signals you are looking for to execute trades.
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 or behaviours.
This can include revenge trading, chasing price from the fear of missing out and generally just being proactive in the market.
Just because you have opened your trading platform, it does not mean that you should execute a trade.
The market gives what it wants to give, when it wants to give it.
Trading should be a reactive activity, don’t force trades for actions sake.
So, when in doubt, stay out and let the opportunities come to you.
12. Give room for your deals 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 favour immediately after executing a deal. Then move quickly towards your take profit with minimal price corrections in between.
Although this can happen, the price can also move against you for some of the time. Sometimes it just takes time for a deal to play out but other times, the trade just won’t work out. Where you place your stop loss will have an effect on the outcome.
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 with minimum loss.
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.
Few things are as demoralizing as being right about the trade but still losing money.
13. Trade with the major trend
Prices move in waves and these waves make up price trends.
It is evident on all time frames.
To minimize risk and improve your probabilities of success, trade in the direction of the dominant price trend. The dominant price trend for your trading style will be relative to the time frames you are trading. The higher the time frame the more dominant the price trend.
The trend is your friend.
14. Trade on higher time frames
Trading on the higher timeframes, 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.
Less can be more. So be patient, it pays to be patient.
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 than it is the 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 favour, you can close portions of your position at incrementally better prices. The benefit of doing this allows you to take profits to minimize the risk of a trend reversal and watching your profits vanish.
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.
That concludes the list of the top 15 tips to better manage risk in trading.
Take whatever you think is useful and disregard what you think is not. You can apply some or all of these tips when trading.
But accepting and embracing risk is something that you must do and manage, if you want to achieve consistent and long term success in trading.
How you go about doing that, is up to you.