Risk Management in Forex Trading
Forex risk management is the pillar of successful speculation. The main concern of every Forex trader is how to preserve capital first, and to make a profit second.
Because of the highly volatile character of the Forex market, a risk management approach is mandatory. Regardless of the strategy, a sound money management system has more advantages than the retail trader believes.
For once, it eliminates emotions. Financial markets are responsible for an emotional rollercoaster, with fear and greed dominating traders sentiments. Thus, objectivity is lost, and lousy trading decisions appear.
However, using a risk management strategy helps to deal with such issues. Traders know what to expect and what is the worst-case scenario. Hence, they won’t be surprised by market movements anymore, but interpret them as part of the plan.
Elements of a Forex Risk Management System
Part of its Forex education programs, a Forex broker can’t stress enough the importance of running a risk management approach to any trading strategy. As such, Forex trading becomes disciplined, and discipline leads to better results in time.
Here are the elements of a Forex risk management system designed to keep traders in the markets for a long time and to profit from trading the currency market:
- Pending orders
- A stop-loss order is mandatory for every trade. Sometimes the markets move so fast that the trader’s account takes a considerable hit if no stop-loss order is in place. The stop-loss order defines the risk willing to take for any given trade. A sound money management system doesn’t risk more than one percent on any given trade.
- As crucial as the stop-loss order, the take-profit order defines the reward. One of the most challenging parts in Forex trading is to let the profits run, but also to book the profits, or to take what the market gives. Finding the balance between the two is no easy task.
- Buy stop
- Traders use a buy stop order when they want to enter the market from higher levels
- Buy limit
- Traders use a buy limit order when they want to enter the market from lower levels
- Sell stop
- Selling takes place from lower levels
- Sell limit
- Selling takes place from higher levels
- Risk-reward ratios
- A risk-reward ratio reflects the relationship between the risk and the reward in a trade
- In Forex trading, the reward MUST always exceed the risk
- Proper risk-reward ratios have the reward at least twice as big as the risk, and, ideally, the ratio reaches 1:3 (traders stand to make three pips for every pip risked)
- Avoid correlated markets
- Some markets in the Forex account enjoy a direct or indirect correlation (g., oil and CAD, JPY and DJIA, AUD and CAD, USD pairs – majors)
- Avoiding them diminishes the risk of overtrading, which improves profitability
- Never put all the eggs in the same basket – hence, diversify the account into cash, metals, commodities, bonds, FX, indices, CFD’s, ETF’s, or whatever the brokerage house has to offer besides FX rates
Pending orders and risk-reward ratios are enough to build a healthy Forex risk management system. The system helps to navigate the ups and downs, the daily volatility in the trading market while keeping the risk in control.
Remember what the focus of every money manager is: to protect and preserve the capital. Once that assured, the profit will come naturally.