Risk Management Basics For Forex Traders

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Takeaway: Forex is risky, but the risk level is set and controlled by the trader.

Risk Management Basics For Forex Traders
Balancing risk and return can be a challenge.
Source: Flickr/Epsos
Currency trading is often described as a very high-risk, high-reward market. In fact, almost every site about forex carries a disclaimer about just how risky forex trading is. However, what is often overlooked is that the risks of forex trading are entirely dependent on how a currency trader approaches the market.

If you want high-risk, high-reward trading, it is there for the taking. If, however, you want to lower your risks (and cap your potential rewards), you can do so in forex just as easily as in any other financial market – perhaps more easily. In this article, we’ll look at some basic risk management that can help forex traders limit their losses.

Ordering Up Risk Control

The framework for controlling risks in forex trading is built right into the order system. There are several different ways to limit your risks using entry orders, but the most important element of risk management is how you exit a position. For this, the stop-loss order is the standard tool. If you trade without a stop-loss order, your risk of a loss is theoretically limitless.

A stop-order allows you to set the amount you’re willing to lose on a position. By setting a stop-loss on every trade, you will always know what the worst case scenario is in terms of the loss on a particular trade. You’ll also be able to calculate the total risk in your trading account by summing up the capital risked in each trade. Without a stop-loss, you can’t know the total risk, so a leveraged trade might have the potential to turn against you and wipe out your entire account before you know what happened.

Setting a Daily Maximum

Although this is far from a hard rule, many traders find it useful to set a daily maximum of losses they are willing to incur. This can be a dollar figure or a percentage of the total account value. This forces traders to take a step back from the market and helps avoid the tendency to start leveraging trades more to “win back” the day’s losses.

The other maximum a trader needs is a maximum limit for leverage. There is no hard and fast rule, but generally you should cap your leverage well below the point where the potential margin call could wipe out an account. You can also avoid temptation to leverage up by requesting a lower leverage ratio on your accounts. Forex brokers advertise the maximum leverage they offer, but that doesn't mean you should use it.

Cashing Out Regularly

This risk control method works on two levels. On the trading level, traders should to be taking regular profits out of the market. It depends on your trading timeframe, but the longer you keep a profitable position open, the further that position gets from the original reasons you opened the trade. Keeping a position open for more profit may lead to you overstaying on a trend and seeing a profitable position suddenly getting stopped out for a loss. You can set your profit targets before opening the position, just as you set your potential losses with a stop-loss, thereby taking the emotion out of the trade.

The second level of cashing out is in terms of overall money management. A profitable trader should pay some of the profits out of his or her account on a monthly or quarterly basis. This is a bit counter-intuitive, as most advice states that the bigger your trading account, the more profit it can generate. However, if you are not paying yourself out a percentage of your profits, you are at risk of working for free because the future value of your account is dependent trades yet to come. If you have a bad month that wipes out a year’s profit, you’ve just lost a year of effort. It is far better to take excess profits out of the market in small payments to yourself, and more motivating in the long run. Think of it as a management fee you pay to yourself.

The Little Things

Although these are better summed up as good habits for traders, the following actions also help reduce your overall risks in the market:
  • Trading with a plan
  • Studying the currency pairs you trade for key factors that cause movement
  • Being aware of global events and markets that may influence the forex market
  • Double checking your order entry before executing a trade to avoid the fat finger problem

The Takeaway

By using stop-loss orders and controlling how much of your trading capital is at risk at given time, you can keep your overall risk under control. In the end, currency trading is only as risky as you let it be. (New to the currency market? Check out the Top 10 Mistakes That First Time Forex Traders Make.)

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About Andrew Beattie
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Andrew Beattie has spent most of his career writing, editing and managing financial content as well as more general web site material in all its many forms. He is especially interested in the future of search and the application of analytics to the business world. He has been a long-time contributor to Investopedia.com and is currently venturing forth on ForexDictionary.
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