In the world of investments, it’s always needed to risk a portion of your capital to gain money. This applies to all asset classes and their derivatives, no matter how much you’re better or what asset you’re risking your capital on.
With the volatility that the forex market experiences, traders should be prepared to face whatever price movement their investment will have. With that in mind, risk management is important in setting expectations and preparing for both good and bad outcomes.
This article will help you through the process of managing your risk in forex trading while giving you strategies and tips on how you could take advantage of risk-based strategies. We will also be going over the common risks forex traders face as well as how to calculate and deal with this risk as it comes.
What is forex risk management?
If a holy grail exists in the trading world, then it would be in the form of risk management. Essentially, risk management is a method of minimizing your losses and maximizing your gains through rules and strategies that a trader sets for themselves before and during a trade.
Risk management is a simple concept that is taught not only in trading but also in other industries. This simple concept, however, is not followed all the time due to human emotion or the lack of a proper system for traders.
In forex, risk management is especially important due to the nature of how forex trading works. Due to the minuscule movement of forex pairs, one would choose to use margin and leverage so that they get a decent amount after every trade. This, however, is a double-edged sword because, together with the chance to gain more money, the trader also puts himself at an equal amount of added risk.
Managing risk involves a lot of preparation as well as knowledge in the market and knowing what kind of trader you aim to be. As a trader, you will have to formulate a set of guidelines and measures that you will follow no matter what happens to the price of your investment. You will be both preparing for the positive and negative outcomes of your trade.
With that said, this kind of management doesn’t happen when the trade is entered, but managing risk happens even before a trade is thought of. Being able to prepare this set of rules is tasking, tiring, and sometimes annoying to some because of the possibility of missing out on the market. But, overall, this preparation will save you a lot of cash in the long run.
In creating this kind of plan, you will not only be dealing with prices, but you’re also going to take into account future news, the amount of capital you have, as well as the number of open trades that you would want to have. You will also be setting your target gains per day or week, depending on your preference.
Below, we have listed all of the risk factors found in forex. Subsequently, we also noted down a lot of strategies in creating your own set of rules that you can use to manage risk effectively.
Common risks when trading forex
The first and most common risk when trading forex is called price risk or also known as currency risk. It is the risk you are facing when dealing with the underlying value of the forex currency pair you are trading. Whether you are long or short on a currency, this is the first thing you should consider.
Price risk determines your profitability and hit rates most of the time due to volatility. You can use this to your advantage if you implement proper strategies that you will encounter later on.
This risk depends on a lot of factors and could even be affected by the other types of risks listed below. Since price is what you are dealing with, knowing the other types of risk but putting priority on price risk will certainly be beneficial in your trading journey.
Liquidity risk comes hand in hand with price risk because liquidity directly affects the price. The presence or absence of liquidity means you’ll be buying or selling a certain asset at a more favorable or disadvantageous price.
Specifically, a more liquid forex pair would have smaller spreads than a less popular forex pair. Market participation influences trading greatly. Trading smaller spreads means lesser risk and losses for the trader.
Sometimes, the liquidity of an asset changes due to incoming economic events. These events could come in the form of government policies or updates on a country’s financial data.
Interest risk deals with the interest rates of currencies involved. This affects volatility as well as potential gains or losses of a client. Traders often experience getting or paying interest if they hold positions overnight.
Additionally, interest rates play an important part in managing an economy. With foreign exchange currencies having transactions worth billions of dollars per day, a small change in interest rate will produce waves around the world. That’s why interest rate changes are one of the most important economic news that traders should pay attention to.
Leverage and Margin risk
To grow your small portfolio into a bigger one, you should use leverage and margin. Greater gains, however, also come with greater risk.
When using leverage, your risk is as exponential as the leverage you chose. Margin, on the other hand, allows you to borrow a certain amount of cash from your broker through margin requirements. Both of these will lessen your room for error and will also make you manage price risk even more.
Overnight risk is a general term that includes interest rate risk, news risk, and other fees that you might encounter when holding a position overnight. Both interest rates and swap fees are something you should look out for, especially when trading big lots.
Although some traders can take in the volatility due to their trading time frame and more lenient stop-loss points, day traders or scalpers should take an overnight risk with more respect. The volatility one would experience, especially when the trading day starts, is usually more than what their regular position might be able to handle. This would lead to immediate losses even if you started the day with a positive value.
As previously discussed, the overnight risk is a big thing, especially when there is news. However, news risk can also be present even during regular trading hours.
A lot of traders try to avoid trading when there is news because of the volatility. Even if you’re sure of how the market will react in the long run, the volatility in the short term will most likely hurt your position and would make prices hit your stop-loss points before you could react.
Managing risk when trading forex
When managing risk, you don’t simply calculate how much you’re willing to lose on every trade. Instead, you should also take into account how much you’re supposed to gain and how often you should be trading.
You should have a grasp on everything that you could control in a market where price fluctuates depending on fundamentals and sentiment. A trader should have a plan that is both consistent and profitable if they want to survive and thrive trading forex. We listed below ways on how to manage risk and how to give yourself the advantage in this volatile market.
Have the basic knowledge in trading forex
The first thing that you should do when trading forex is to know what you’re jumping into. Forex is a really volatile market that statistically causes traders to lose more than they gain. However, this is mainly due to bad risk management strategies.
Knowing the basics of forex will allow you to navigate forex websites and platforms with ease and mastery. A trader should know how to enter orders on their own together with the appropriate trading details such as take profit and stop-loss points. Other terminologies that traders should know include lots, bid and ask, spreads, swap fees, and pips.
You should also be able to develop your skill in charting because this plays an important role in managing and monitoring your trades. Since forex trading is a bit more complex compared to stock trading, you should also have a basic understanding of long and short positions, so you don’t enter a wrong trade.
When trading for the first time, you will also notice the variety of forex pairs available for you to trade on your broker. Usually, a broker would offer three different kinds of forex pairs, but these would be unlabeled when you would start trading. These classifications would include major, minor, and exotic pairs.
Practicing with a demo account
For newbies and professionals alike, using a demo account is a free ticket to try out new and existing strategies to gain an edge in the market. Through demo accounts, clients are given a large amount of virtual cash, which they can use to set up manual or automatic orders that simulate real-time market conditions.
Positions made using demo accounts also reflect on your demo portfolio, which shows you your gains and losses since you traded a certain asset. You would be able to gauge if you are a profitable trader by following your set rules and conditions when trading since you will be able to definitely apply your demo trading concepts to live accounts.
Keeping emotions in check
As previously mentioned, it is important to follow your rules and never deviate from them. Traders, especially those that would monitor charts on a daily basis, experience either the fear of missing out or the fear of being wrong.
Both of these feelings play a negative role when trading and when managing risk. These either will make you exit a position early or start a position that doesn’t follow your trading conditions.
To gain an edge in the market, you must, at all times, be prepared to miss out on some trades or lose in others. You must always remember that you should wait for the market to meet your price before entering your order because this will lead you to more chances for success.
Creating trading rules
When developing your own set of trading rules, first, you must figure out what kind of trader you are. If you are satisfied with small gains and can monitor the market every day, then you can become a day trader. With day trading, you must open and close positions on the same day to avoid overnight risks that may come from interest rates, swap fees, and news updates.
Alternatively, if you’re looking to trade with a longer time frame in mind, you can become a swing trader that trades longer trends to capture bigger gains. With this, however, you should have bigger stop-loss points due to the volatility of forex pairs.
When trading forex or even other asset classes, it is important to measure the RRR or the risk-reward ratio for every trade. With this RRR, it is possible to be profitable even if your win rate is just a little over 30%. As long as you minimize your possible losses and maximize the times you are right, you will earn more than you lose in the long run.
Some trading rules also dictate when to trade and what to trade. As a tip, it is best to trade only the most liquid of currency pairs to avoid losses due to spreads. This means that one should only trade major currencies or trending minor currencies because that is where market participants are.
Additionally, some traders even choose to trade at a certain time because of the presence or the absence of volatility. Trading during a certain session, such as the Tokyo session, will allow you to capture bigger moves for JPY pairs or the Japanese Yen pairs.
Mastering the use of leverage
When using leverage, you are exchanging the chance to gain more for the added risk. In forex, leverage is essential because of the minimal movement of forex pairs, but this also means that you need to take account of your risk even more.
Highly leveraged positions mean that you only put a smaller amount of your capital but also risk a bigger chunk of it in the process. This also means that you have to tighten your stop-loss levels even more and adjust your RRR to still profit reliably.
FAQ: Forex Risk Management Strategies
How do you use risk management in Forex?
The first step to using risk management is knowing how much you’re willing to lose on every trade. Usually, the best traders only risk a percent of their capital on every position, no matter how sure they are on a possible trading scenario. Also, prior to trading, you should also have a general plan on taking profits and cutting losses.
Next, you should check assets you’re interested in trading if any of them shows a good trading opportunity. Remember that before entering a trade, you should identify where you would exit a trade and stick to your plan. This way, your risk management strategies would be followed, and you would only lose a percent of your capital at most.
How is risk management calculated in forex?
To calculate your risk, you should find how much you’re willing to lose first on every trade. Assuming that you have 100,000 USD, a good trade should risk only a maximum of 1,000 USD on every trade.
Afterward, the trader should know where a stop loss point should be placed. A stop-loss point is a price level where the trader thinks that the opportunity is wrong and invalidated. When this stop loss point is reached, they will lose no more than 1,000 USD.
By using calculators available on brokers and third-party websites, it is easy to calculate your ideal stop-loss level by just inputting details such as trade amount, lots, asset traded, and the entry price.
How can you reduce risk in forex?
To reduce your risk, you must follow your rules at all times. Whether it’s from entering or exiting a trade, you must not give in to the anxiety of missing out or even the fear of losing an opportunity. If an asset reaches your stop loss level, you must respect it at all times because that is what will protect you from losing more.
Why is risk management important in Forex?
Risk management is important in forex because it prevents you from losing more than what you were initially willing to risk. In forex, where volatility is both expected and unexpected, you must be prepared for whatever outcome the market gives you. Additionally, with enough capital saved up, you can bounce back from a losing trade because with risk management, you only lose a small fraction of your portfolio.
Risk management isn’t just about controlling the amount of money you lose, but it’s about the process that you take into ensuring that your capital is safe. From controlling your emotions to masterfully selecting the best asset to trade at the right time, the things you learn will gradually form into your own set of rules that will make you thrive in the forex market.