19 October 2023
Risk Management in Forex Trading: A Comprehensive Guide
The forex market is undoubtedly one of the largest financial markets in the world. According to a Bank for International Settlements (BIS) survey, the industry handles transactions totalling about $7.5 trillion daily.
With all this money up for grabs, financial institutions, trading firms, and individuals can make massive profits but equally huge losses. That's why applying risk management is necessary. This practice enables you to set measures to protect you from any adverse consequences of forex trades. As such, you can avoid catastrophic financial losses and emotional decisions that might blow up your account through risk management.
Executing risk management strategies promotes consistency in trading decisions by influencing you to follow a disciplined and systematic approach for long-term profitability. Most importantly, implementing risk management measures can mitigate unforeseen economic, political, and social events that affect the forex market. Now that you know how important risk management is, what strategies can you apply? Are there tools that can help you regulate risks more effectively? Read on to learn more.
Risk Management Strategies
Some risk trading measures you can apply to succeed in forex trading include stop-loss orders, position sizing, hedging, and leverage control.
Set stop-loss orders
Stop-loss orders are popular risk management strategies by traders. The order automatically exits an adverse position when the market price reaches a certain point. This helps mitigate your risk exposure and safeguard your funds from substantial losses. For instance, if you place a trade hoping that the asset's value will increase, but instead, it reduces, the trade will close immediately after the asset hits your stop-loss price, preventing further losses. At times, the markets act erratically and generate price gaps. Therefore, it's advisable to set stop-loss orders to ensure you don't lose over 2% of your equity for any given trade.
Manage your position sizes
Correct position sizing can determine whether you live to trade another day. The process entails deciding the amount of money to allot to every trade based on your risk appetite, market conditions, and account size. The money you trade dictates your returns and risks. When you bet big, chances are you may win big. The losses might be high, too. So, which amount is correct? First, work out your account risk limit for each trade. For example, setting the risk limit at 1% on a $25,000 trading account indicates you are willing to lose $250 per trade.
Next, turn your attention to the trade before you decide the pip amount you are ready to risk. Pip risk on every trade is the difference between the entry and stop-loss order points. If you purchase a EUR/USD pair at $1.2141 and set a stop-loss at $1.2131, you are risking 10 pips. Pip risk often varies based on strategy or volatility, with some trades having as low as 5 pips of risk and others having as high as 15 pips of risk.
Now that you know the account size and pip risk, it's easier to determine the position size. Based on the aforementioned examples, divide the account risk ($250) by the trade risk (10 pips, which is $10 for a mini lot) to get the proper position size. You must trade 25 mini lots ($250/$10) to give you the risk percentage that aligns with your trading strategy. As you use this approach, you'll realize that position sizes increase proportionally to the increase in your account. The reverse happens if your equity reduces.
Take advantage of hedging
Apply hedging to safeguard your position in a trade from an adverse move. This is where you protect your trading position in a currency pair from an unfavourable move. Hedging is recommended if you are worried about an event or news triggering volatility in the forex market. There are two approaches you can implement. One is to hold a short and an extended position concurrently on the same currency pair to protect a current position fully. As a result, you eliminate all the risks linked to the trade as long as the hedge is active.
The other option is to purchase forex options. For instance, buying put option contracts may be necessary if your currency pair is in an extended position. Doing so allows you to take a short position on the asset's price, where you can sell your pair at a specific price (strike price) to the options seller on or before a specific date to get an upfront premium.
Imagine you are long EUR/USD at 1.2685, predicting the pair's price will increase in the future, but are also worried the value may go down if an imminent economic announcement becomes bearish. You could hedge risk by buying a put option contract using a strike price just below the present exchange rate, such as 1.2660, with the expiration date being somewhere after the announcement.
What if your currency pair is in a short position? Which forex option is available for you? In this case, the ideal move is to purchase call option contracts to mitigate risk arising from a move to the upside. This entails buying a contract with a strike price slightly higher than your currency pair’s trading price.
Regulate the use of leverage
Using borrowed money to invest, your leverage allows you to trade large positions. For instance, if your leverage is 50:1, you can trade up to $50,000 worth of currency on an account with $1000. As such, you may be tempted to use your leverage to determine your position size. While using leverage seems like a good idea to magnify your profits, failure to regulate it efficiently could put you at risk of making huge losses. The best way to protect yourself is to limit the leverage used. If you are a beginner, consider working with low leverage levels, such as 1:5 or 1:10, gradually increasing as you learn more about it. With time, you can select the leverage you are comfortable with based on your risk appetite, trading strategies, and experience.
Although forex trading is lucrative, it can also present many psychological challenges. Many traders struggle with the mental challenges of risk management, which can cause poor performance and substantial financial losses. In light of this, the common psychological challenges include:
Greed often causes traders to overtrade by entering numerous positions to optimize gains or hold on to losing positions, believing it will ultimately turn to their advantage. If you give in to this emotion, you will likely not manage your risks efficiently. You may take excessive risks and ignore measures that may help reduce trading risks. Greed can also lead to overconfidence, influencing you to make poor decisions.
Different forex traders demonstrate fear in various ways. Some are afraid of losing funds and are reluctant to initiate trades or opt to exit unprofitable positions hastily to avoid making more losses. Then there is this group that tends to make trading decisions for fear of missing out. As such, they often chase trades at unfavourable prices so they don't miss out on prospective gains.
Other traders are overly careful and over-assess market data for fear of being wrong. No matter what category a trader falls in, one thing is clear—fear affects their trading decisions negatively. Therefore, a fearful trader cannot reason, even regarding risk management.
The lack of patience often makes some people make impulsive moves. This may manifest as traders not waiting for the correct trading opportunity, copying other people's strategies, entering and exiting positions based on their emotions, etc. Managing risks may also be challenging for such traders as they hardly take time to identify and assess their trading moves. Either they are too excited to reason or obsessed with getting quick profits. Unfortunately, things ended badly, with most of them making massive losses.
Anxiety is an inevitable feeling that traders experience in forex trading, given the volatile and unpredictable nature that characterizes this market. People who cannot calm themselves amid market upturns and downturns tend to make poor decisions. As a result, they might divert from sound planned risk management practices and act unreasonably.
Have you ever found yourself in a situation where the negative emotions you experience from losses are stronger than the feelings you experience from making profits? Well, this trading psychology is what is called loss aversion. It can influence you to make biased risk management decisions as you avoid exiting positions in anticipation of a reversal. You will likely experience considerable losses in the long run, especially if a trade moves against you continually.
How to overcome mental challenges
There are several approaches you can take to address the challenges. Here is a compiled list of the solutions:
Create a comprehensive trading plan
Developing a trading plan helps eliminate emotions from the trading process. A trading plan lets you define your entry and exit points, profit targets, risk management criteria, etc., so you don't trade recklessly. However, you need a lot of discipline to stick to the plan. Whenever you experience negative emotions, such as greed, fear, or stress, just take a deep breath and use your trading plan as a guide.
Take breaks regularly
Sometimes all you need to calm your nerves and relax your mind after engaging in a stressful trading session is a break. This lets you disconnect your emotions from the trading and have enough time to reflect on your actions. Consequently, you can make sound decisions when you resume trading and manage your risks more efficiently for improved outcomes.
Practice emotional awareness
Based on your trading experience, what actions signify fear and greed on your part? Is it impulsivity, stalling, or too much risk-taking? Awareness of these emotions is key to helping you regulate your actions in trading. Whenever you experience these feelings, try to step back and reanalyze your decisions objectively. For instance, you can determine whether the risk management approach you have chosen is ideal based on the trading strategy you are working with. You'll notice that you can make better choices and identify weaknesses in your trading or risk management practices when emotions aren't involved.
Pay more attention to the process than the outcomes
Understand that forex trading is a continuous process, so you should adhere to your trading and risk management practices and not focus on short-term profits or losses. Developing this mindset helps decrease emotional attachment to individual trades and enhances a more reasonable approach.
Set sensible goals
Coming up with realistic goals is an essential component of risk management. Don't be tempted to think that forex trading is a get-rich-quick scheme. Instead, it's a long-term investment and should be treated as such. This will help you set clear goals that go hand in hand with your risk tolerance and financial goals. You should also understand that making losses during trading is normal, and not every trade will earn you money. Therefore, it's possible to manage your expectations and take a patient approach, allowing you to avoid impulsive decision-making that normally leads to needless risks.
Tools and Platforms
The correct risk management tools in today's fast-paced trading world can make all the difference between success and failure. Although numerous options are available, figuring out where to begin might not be easy. Don't worry, though. These trading tools can help you:
Position size calculator
A position sizing calculator is an invaluable tool every trader should use. It enables you to manage trading risks better and prevents you from burning your account on a single trade. By just keying a few inputs like currency pair traded, account size, risk percentage, and stop loss, the calculator computes the estimated amount of currency units you need to trade to regulate your risk per position. This calculator saves you time because you don't have to determine position sizes manually.
There are multiple volatility indicators, like Average True Range (ATR), Bollinger Bands, Parabolic SAR, etc., that you can use to manage your trading risks. The information you obtain from these tools enables you to make informed decisions on how to implement risk management approaches such as stop-loss levels, position sizing, and more.
If you want to control your trading risks more confidently, use the correlation matrix. It showcases a grid of correlations between different currency pairs and summarizes the available trading options. Generally, numeric values (-100 to +100) display the grid, but the tool also integrates colour coding, which allows you to pinpoint strong or weak correlations at a glance. By using this tool, you can diversify your trading and decrease the overexposure risk.
Risk-reward ratio calculator
Do you want to evaluate a trade's prospective profit relative to its potential loss to see if it is worth engaging in? Consider using a risk-reward calculator. It will assist you in calculating a position's best targets and their respective reward-to-risk ratio based on your trading strategy. It's a powerful tool to establish potential risks before initiating any trades. For example, if you get a risk-reward ratio of 2:1, you earn twice as much profit as you could potentially lose. So, participating in such a trade is beneficial.
An economic calendar is a must-have tool. Through it, you can learn a lot about upcoming news events from around the globe. It doesn't matter the timeframe you trade on; updating on imminent calendar events daily is essential because they will likely affect the forex market directly. This way, you can avoid opening positions during high-impact news releases and thus manage potential risks. An economic calendar also allows you to compare the economies behind every currency and make sound trading decisions.
Have you ever considered trading in a virtual environment? If not, then you are missing out on a lot. This is a great platform to gauge whether your trading strategies and risk management approaches work. The good thing about such environments is that you won't use real money, allowing you to test your approaches in different market conditions. Eventually, you can adjust your risk management techniques to suit your needs.
You can have the best trading strategy that generates massive profits, but your trading success is limited if you fail to apply a sound risk management approach. You could lose it all within a very short period. To prevent this, ensure you identify the best approach to regulate your risks. You can apply one or more strategies recommended here based on your trading preferences. Not only will the practices safeguard your capital, but they also increase your chance of experiencing long-term success in the forex world.
Disclaimer: Any information presented is for general education and informational purposes hence, not intended to be and does not constitute investment or trading or tax advice or recommendation. No opinion given in the material constitutes a recommendation by M4Markets that any particular investment, security, transaction or investment strategy is suitable for any specific person.
It does not take into account your personal circumstances or objectives. Any information relating to past performance of an investment does not necessarily guarantee future performance.
Trinota Markets (Global) Limited does not give warranty as to the accuracy and completeness of this information.
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