Managing Forex Trading Risk

Table of Contents
Chapter 1: Educating Yourself About the Forex Market
Chapter 2: Identifying Good Forex Trading Opportunities
Chapter 3: Developing Your Forex Trading Strategy
Chapter 4: Managing Forex Trading Risk
Chapter 5: Become a Successful Forex Trader

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Chapter 4: Managing Forex Trading Risk
What is Risk Management
Use Only Your Risk Capital
How Much to Risk Using Stop Loss Orders
Other Ways to Lower Risk

Chapter 4: Managing Your Forex Trading Risk

For new entrants to forex trading, the most important thing to remember is that the chances are very, very slim of your turning out to be the next George Soros, walking away with $1 billion in a day. The fact is that a large majority of forex trades are unsuccessful. It is only a handful of traders who really achieve the kind of spectacular profits that lure investors to this market.

Forex trading comes with huge risks and unless you are very careful and disciplined, these will almost certainly wipe out your capital. It is next to impossible to trade in forex without sustaining occasional losses. The trick is to restrict losses to a level that your capital can absorb without sustaining too much damage.

Successful traders are not those who had a streak of luck and had the good timing to be ‘in’ the currency right then. Success rarely depends on luck in forex, but skill can definitely guarantee decent returns by keeping the loss to a minimum.

A trader may have the perfect strategy based on a complete understanding of fundamental and technical aspects. He may have selected the perfect currency pair. But a completely unexpected change in any one of the fundamental factors can completely throw his currency pair off track. The unpredictability of the market makes it impossible to guarantee success every time and renders the market very volatile and highly risky. That is why the most important tenet of forex trading is risk management.

What is Risk Management

Effective damage control requires that you identify and address potential risks even before you enter a trade. Once you have taken a position in trade, it can change very quickly and unpredictably. If things are not going in your favor, you will be left with very little time to realign your strategy and stop losses. That is why it is critical to assess and address risks well in advance.

The right strategy alone will not bring success in forex. Applying the right strategy at the right time makes the winning combination. To identify the right time to carry out the right action, it is essential that you understand the risks that may arise and mitigate them.

Risk management, thus, requires that you identify the worst case scenario for each trade and prepare yourself for damage control in case that scenario arises. It also involves managing your investment so that the damage caused is limited to a level you determine beforehand. When you develop your trading strategy, you must factor in any risk that you believe may arise. The strategy must be developed with a view to absorbing the inevitable losses that occur in forex while avoiding a complete wipeout of your capital.

Use Only Your Risk Capital

The most basic premise when you begin forex trading is that you use only your risk capital. On no account, should you use funds that you cannot afford to lose. Your risk capital is the amount you can afford to lose completely without hurting the way you live or the essential expenses that you have to make.

How Much to Risk Using Stop Loss Orders

Once you have identified your risk capital, the next step is to find out how much of this amount you can lose without hampering your ability to keep investing. You will need to establish a specific ‘allowed to lose’ amount for each trade. This can be set by using a stop loss order. Stop loss is the level when an unfavorable trade must be stopped so that further losses are not incurred.

Most traders decide on a certain percentage as stop loss on each trade. This means, that on every transaction you are allowing for a maximum loss of that percentage of the capital you have invested in it. If at any point, this level is breached then you will immediately take action to stop further decline by closing the position. Remember that the major portion of your investment capital comes from your broker. You should restrict your loss to the amount that you can repay from your own funds.

For day trading, traders typically like to keep a stop loss of 2%. Over a one month period, forex traders are advised to keep an overall stop loss of 6% on all trades. This means that you can allow for a maximum loss of 6% of your capital in that month.

If your broker doesn’t take long term stop loss orders, then to find out when these limits are breached, you need to compare the state of your trades and margin account at the end of every day. Match these figures with the sum you started out with on the first day of the month. If you have just reached the 6% limit, close all your positions and stop trading until the next month.

Keep checking your current capital in the margin account as well as the status of open trades to determine what you starting capital is at the beginning of each month. Make sure you stick to the stop loss no matter what happens. It is this discipline that insulates smart forex traders from the risks inherent in this market.

If you are risk averse, your stop loss may even be lower than this, but never breach the 2% and 6% rule. Similarly, you can use different stop loss levels for different trades. For example, for a stable currency pair that usually shows very little volatility, you can set a 0.25% stop loss because a more dramatic change may be the beginning of a nosedive. A more volatile currency pair, involving a weaker currency, can fluctuate much more during a day so you can set its stop loss at 2%.

Once you have determined the stop loss limit you want to have, it is time to put it into action. Every time you plan on entering a new trade, calculate how much you can afford to lose within the maximum of 2%. Communicate your stop loss to your broker or enter it into the trading platform.

Make sure that whichever method you are using, it is completely reliable and the order will be executed when the trigger price is reached. Most of the modern trading systems automatically close your position when stop loss level is breached. If you do not close your position on that day, then re-evaluate at the end of the day and adjust your stop loss level if needed.

Other Ways to Lower Risk

  • Diversify: It is possible to spread the risk by trading in many currencies with mini lots. This lets you limit your capital exposure to each pair and your losses in one can be counterbalanced by gains from another.
  • Trailing the stop: Continuously raising your stop loss limit when a currency pair is moving upward is called trailing the stop. This lets you limit the amount you can lose while allowing you to make the most of the gains.

A winning strategy, which has given you many gains, may throw up a loss under some circumstances. This does not mean that the strategy is no longer a good one. It can’t be emphasized enough that losses are an inevitable part of forex trading. Review your strategy and see if all your basic assumptions still remain the same. If they are and your strategy still appears sound, then simply absorb the loss and move on.

In forex trading, you need to be prepared to take small losses, manage risks to avoid big losses and make enough gains to give you a good profit even after covering your losses.

Next Chapter: Become a Successful Forex Trader