How To Manage Risk In Forex Trading
Regardless of how knowledgeable and intelligent a trader maybe about the markets, their own psychology and emotions will cause them to lose money. What can be the cause? Are the markets so enigmatic that only a few succeed in making profit?
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Most forex traders lose money. They fail to understand and apply proper risk management rules in their trading. Risk management means knowing how much you are willing to risk and also knowing how much you are looking to gain in a trade.
Risk-reward ratio is very important for you to know and understand. As a trader you should calculate a risk-reward ratio for every trade that you make. In more simple words, you should have an idea of how much you are willing to lose if the trade goes against you. You should also know how much you are expecting to make in a trade. A general rule of thumb that you should apply is that your risk-reward ratio should not be less than 1/2. With a solid risk-reward ratio, you can eliminate a trade that is not worth the risk by not entering it.
There are two ways to place the stop loss order.
1) Initially place the stop loss at a reasonable level.
2) Trail the stop meaning move it forward towards profitability as the trade progresses.
Another volatility based method is to use the Parabolic SAR indicator. It displays a small dot at the point on the chart where you should place the stop loss. Parabolic SAR is a volatility based indicator. You can find it on the charting software provided freely by your broker.
Foreign Exchange Risk Management Concepts
Veteran and amateur traders alike must understand forex risk management methods if they hope to have any chance of financial success in the long run.
Unfortunately, many traders do not think about foreign exchange risk management at all. Or if they do, they only think about market risk. Serious traders understand there are at least 5 types of risk associated with trading forex, and market risk is only one small one.
In this article we’ll explore the 5 different types of risk you’re exposed to when trading the forex markets, and ways you can lessen, or even eliminate, your exposure.
Please do not take this as an exhaustive list, nor as a deterrent to trading, it is only meant to help expand your awareness of foreign exchange risk management and prepare you for a long term, profitable run as a forex trader.
The 5 Major Risks in Forex and How To Manage Them
#1. Broker Risk: A broker is a business like any other, and as such they can face the same problems any regular business can, including bankruptcy.
Experienced traders might remember the 2005 Refco fiasco where one of the largest and most respected brokerage firms in the forex markets went bankrupt. The effects of this are still being felt today.
Always spend some time thoroughly investigating potential brokers before you get seriously involved with them.
#2. Technology Risk: In a trading world run almost entirely on computers, the effects of a hard drive crash, power loss or Internet connection drop out can be drastic.
I strongly suggest you backup your computer on a daily basis, preferably to an off-site location you can backup from in case of fire or theft. Traders with serious commitment to the markets, or sizable portfolios, should invest in fail-safe backup systems including generators and surge protectors.
Some people might laugh at going to these lengths, however anyone who has experienced a serious computer crash knows how devastating it can be, and it could be a lot worse if you were caught in a trade with no way of getting out.
#3 Market Risk: How market changes affect your positions. The most common type of risk people associate with forex.
The most sure-fire way to alleviate market risk is to trade using a proven trading system that integrates foreign exchange risk management strategies at the base level.
This includes having set entry and exit points, profit targets, and stop losses.
#4. Economic and Political Risks: Political policy changes, major economic emergencies and governing authority intervention can all have an impact on a country’s currency value.
You can avoid these type of risks by using a trading plan that integrates solid foreign exchange risk management methods and identifies issues before they impact your positions.
#5. Country Risk: Finally, there is the risk that a country won’t have the money to meets it’s financial commitments, and will default.
Defaults can have serious effects on many other financial instruments throughout the country, as well as in other countries doing business with that country.
You can avoid these risk by trading only the major currencies and staying clear of emerging markets and countries with serious financial deficits.
I hope it is now clear that the risks involved in trading forex are deeper than the surface market risk most people are familiar with.
Luckily, many existing trading systems have in-built foreign exchange risk management strategies to deal with, and eliminate, many of these risks.
However, even the most sound foreign currency risk management strategies are still not perfect, and there will always be some risk involved when trading. Always use your own best judgement about your risk tolerance levels and never trade above your head.