Risk Management in Forex Trading

Risk management is the practice of limiting or reducing risks associated with trading or investing in the financial markets. From a theoretical perspective, rewards are always associated with different levels of risks and when it comes to trading, it’s no different. It’s one of the most important aspects of a trader’s journey and could make or break any investor out there.

There are a variety of factors that a trader can focus on to make sure the risks associated with certain traders are worth it and not anxiety-inducing.

There are several important elements to proper risk management and keeping them in mind will help traders navigate the highly dynamic but sometimes treacherous financial markets.

Risk appetite

When it comes to risk appetite, it starts with the person and their tolerance towards losses. Some people are more aggressive, willing to lose a lot if they truly believe in a specific opportunity, if they also win big on other trades that do work out. Others may be more on the conservative side, settling for smaller potential losses in return for smaller potential profits. 

A good rule of thumb is to risk between 1-5% of your account balance per trade. Even at 5%, this gives you a fighting chance if many consecutive losses take place and you’ve had a bad run in the markets.

Position size

In line with your risk appetite and what you are willing to lose per trade, the position size is determined according to the mentioned criteria. If you have a small account but looking to risk 5% per trade would define a position size that is larger than a risk tolerance of 1% per trade. It’s all relative to what you aim to achieve in the markets in terms of risk and reward.

Stop loss

The stop loss is the price at which you are willing to close to the trade for a loss. If set, the trade will close automatically once that price is reached. The stop loss is determined based on factors such as your position size and risk per trade. 

A stop-loss does not only limit your losses but could protect you from sudden and adverse market movements that may not necessarily be invalidating to your trading strategy, and instead, could be sudden and unexpected in nature. Nonetheless, if your stop-loss is hit, you should make sure your strategy is fit to absorb and learn from being incorrect in your analysis.

Stop losses should be relative to the reward you are seeking from the market. If you believe your stop loss needs to be 100 points and the product you are trading could return 300 points, your risk to reward is healthy and skewed to provide you with a good return and protection from future losses. 1 win of 300 points can alleviate the losses of 3 failed trades of 100 points each.

Traders should look to make twice as much as they are willing to lose and preferably more. This is where being right comes in. the better risk to reward ratio you are employing, the more wrong you can risk being. 

If you make 400 points per trade and you risk 100 points every time, you only need to be right 3 times out of 10 to make a profit of 500 points. Such a ratio is not easy to achieve but a more modest estimate should be 1.5 or 2 times your stop loss.

When it comes to the risk to reward ratio, it’s worth noting that a trader who manages to win many trades could settle for a smaller risk to reward ratio. For example, if a trader can win 6 out of 10 trades, they can go for a 1:1 risk to reward ratio which means the profit is equal to the potential loss. 

In this scenario, the trader would come out with a winner. Smaller profit levels may be easier to achieve than larger ones which would mean the trader is less likely to hit their target every time.

Leverage

Leverage is another important factor to keep in mind. While having higher leverage does not necessarily mean higher risk, the temptation and availability of higher leverage could potentially be disastrous for someone who has made a series of losses and looking to make back some of the losses in the form of highly leveraged positions.

Overall, traders who have used lower leverage were statistically more profitable than those who used higher leverage. At the end of the day, you only need so much leverage to open positions that could bring you the returns you are looking for without the added risks and consistent traders tend to look at percentage returns versus actual money generated.

Emotions

Emotions play a very important role in trading. It’s imperative that traders remain indifferent to wins and losses. One should not be overly happy with big returns and should not be too concerned with losses. It’s all part of the game and trading is a business. Losses can happen and should be managed accordingly.

Sometimes traders may open positions out of boredom or revenge to losses they have accrued trading the markets. This should be avoided at all costs. The more mechanical a trader is the better odds they have in making profits trading the markets.

It’s worth mentioning that no one is completely devoid of emotions, after all, we are humans. Mastering emotional control is a skill that comes in handy in trading and even the slightest improvement in keeping cool under pressure gives traders a much-needed edge to become consistent and possibly successful and profitable in the markets.

Be wary of the news 

Aside from selecting the financial products that match your trading needs and risk appetite, it’s important to keep potential economic releases in mind. While some news can be sudden and unpredictable, the ones that are scheduled ahead of time should be taken into serious consideration given that they may affect your current positions. 

Consider widening your stop around certain releases or maybe exiting part of your position to protect against adverse movements in the event the price goes against your initial direction. On certain occasions, an economic release may help support your position and move it closer and faster to its intended target. They are not always a potential risk to your account.

Finding the right market

Not all trading products are equal. For example, bitcoin, seen in Figure 1, and other cryptocurrencies can be highly volatile, exhibiting moves more than 30% in a day. Others may not be so fast-moving and tend to move in a more orderly manner. Finding the right instrument for you means creating stability throughout your trading journey. 

Figure 1

There is not a clear formula for this. Someone looking for small moves to trade using high leverage may find a more peaceful approach with low volatility instruments while someone with the same characteristics could enjoy the rawness and speed of a highly volatile instrument which could give him a similar outcome in a short period of time.

A conservative but long-term trader may choose a highly volatile instrument if they plan to hold smaller positions with bigger stop losses. Effectively, they do not care about the volatility and are more concerned with the long-term outcome of a specific instrument.

Journal keeping

Just like people keep diaries, traders may choose to keep trading diaries or journals. Logging the different aspects of their trading day including the trades and their outcome may help them become more aware of their advantages and disadvantages. 

Going back and reviewing certain traders, regardless of their outcome may help new and experienced traders better understand current and future traders and find out the best way to manage them, especially if things don’t go according to plan.