Forex Risk Management
‘Higher the risk, greater the return’ – the most cited excuse by traders when they take on a risky endeavor. But they tend to conveniently forget that risky trades have a low success rate too. Also, generally in trading (in most cases), the number of losses exceeds profits. Traders overcome this predicament by earning more profits in their successful trades. Hence, risk management takes precedence over strategy in Forex trading. Because to stay long in the league, one needs to cut short his losses and make the most whenever he is right.
What is risk management in Forex trading?
In Forex, the risk is the potential loss a trader is susceptible to incur in a particular trade.
And so, risk management is the meticulous process of mitigating the potential losses by reducing the exposure in each trade.
The #9 tips which follow will help you to cut your losses as well as enhance your profits.
#1 – Stop loss: The First & Foremost in Risk management
Whether you may be a fundamental investor or a technical trader, there is always a likelihood of your analysis being wrong or to misconstrue a piece of information.
Hence, use a stop loss order. By defining a stop loss value, the moment you enter a trade, you confine the risk to a particular value.
There are two advantages in doing so – one it alleviates your stress, the next is it acts as a safety net.
#2 – Trend is your Friend
It is an old adage, but still works out.
9 out of 10 times you are bound to make profits when you follow it to the core.
But don’t look for reversal trades, though it seems lucrative, it is still deceptive and it fails more often than not.
#3 – Use pullbacks for entry
The most common characteristic of newbies is that they tend to buy at the top and sell at the bottom.
Going with the trend is what technical analysis is all about, but buying at the top (or selling at the bottom) exposes you to higher risk.
There is always a pullback in any rally since traders book profits and your stop loss order will not stand a chance in most cases.
Also, you tend to close out the trade soon, fearing a pullback, if it moves in your favor. It wouldn’t be a decent reward considering the risks associated with the trade.
So instead of fearing a pullback, leverage it to your advantage. Use it as your entry point. It minimizes your risk and maximizes your profitability.
#4 – Master the basics of support and resistance
Support and resistance, trendline are the fundamental aspects of trading.
And the thumb rule of trading states that
- For long trades, use support as the entry point.
- For short trades, use resistance as the entry point.
- The trendline is deemed to hold than break.
So what if a contrarian happens?
Supports, resistances and trendlines are not invincible. They do break. And when it happens, don’t pounce on it instantly.
There will always be a pullback to retest the broken area, which is the ideal entry point.
These kind of entries are low risk and high yielding. It is the combo of tip #3 and #4 (of Forex risk management) and has a high success ratio too.
#5 – Trade with an optimal lot size
There are two styles of risk management in forex trading, concerning lot size.
One is to go with same lot size for all trades.
The other is to risk the same dollar (or your currency) amount for all your trades.
The former is an easy way and you just have to have the discipline to maintain same lot size for all your trades.
While the latter is an advanced method and requires strenuous effort to calculate lot sizes on different pairs, pertaining to a singular dollar figure, i.e. for a narrow stop loss, increase the lot size, whereas for a wide stop loss, decrease the lot size, but the risk of the trade remains the same with respect to dollar amount.
As you go down the road of forex trading, you tend to skew towards the latter, since it gives the leeway to enter risky setups at low risk.
#6 – Don’t put all your eggs in one basket
If you’re confident about a particular event, why not make the most out of it?
Well, you can, but there are two caveats. One is you can be wrong, which happens most times and the other is, the market can be crazy, at times.
If you’re of the ostensible notion that the market is always right, then you have to take it up with legendary investor, Warren Buffett, who believes it is always wrong.
So, before you or the market realize that either one of you is wrong, it could be too late.
Also, market dynamics shift quite frequently.
Hence, the prudent choice of risk management suggests to mix it up to stand a chance in forex trading.
#7 – Don’t overuse leverage
Leverage is a double-edged sword.
If you win, the reward is handsome. But if you lose, the loss can be gruesome.
As the brokers say, losses can even exceed capital because you’re simply borrowing money from your broker and you have to repay it whether or not you make a profit.
The thumb rule of risk management states that not to lose more than 2-3% of your capital on a single trade since staying in the league often matters most than profit-making in Forex trading.
Therefore, use leverage to your advantage, but never overuse it.
#8 – Reduce your exposure to correlated pairs
There are many correlated pairs in forex trading.
The movement of one pair affects the other or both move in tandem.
So, if you take position concurrently in both the correlated pairs (say long in both GBP/JPY and EUR/USD), the most likely scenario is that both will either hit the target or stop loss together.
The risk exposure to a particular event enhances significantly. So, it is wise to avoid taking positions in correlated pairs.
But do remember, the currency correlation changes sporadically and one has to be vigilant in identifying it.
#9 – Hedging
Hedging is the process of taking contra-trades (buy and sell) on the same currency pair at the same time.
The net profit or loss is null, but with proper timing, one can make profits or use it as a risk mitigation tool.
Take, for example; you are in a positional short trade in EUR/USD since you expect the long-term trend to be bearish. However, the short-term trend is bullish and the price moves against you. In an ideal scenario, you wait it out and hope the long-term trend plays out soon. The risk exposure is enormous in these kinds of situations.
So, to neutralize the risk, one can hedge by initiating buy and sell trades in EUR/USD at the same time. When the short term (bullish) trend dwindles, one can close out the long position and retain the long position.
Thus, one can reduce the risk in long-term positional trades and squeeze the maximum out of short term swings in the due process. But it takes years of experience to master hedging. And hedging is always a handy tool in your risk management quiver.
Conclusion – Forex Risk Management
Reckless driving isn’t going to take you to your destiny; likewise, reckless trading isn’t going to take you to paradise. Markets, in general, are a paradox and no one can say for sure, what is going to follow next. And where there is money, there is always risk involved. So in a nutshell, one has to tread the waters and make money in a deceptive environment. But it is indeed possible by deploying prudent risk management techniques in forex trading.