Forex risk management – How to manage risk in forex trading
Risk management in forex trading or just about any financial markets trading is the core to your success in trading. Risk management is also a very broad topic and encompasses a plethora of various aspects.
It is commonly said that good traders manage risk while bad traders chase profits. The truth cannot be further from this.
Most traders that you come across in place like forums, etc. often end up spending too much time in finding the perfect trading strategy or the best currency pair to trade.
However, only a few traders spend the same amount of time in trying to understand forex risk management. Whether you call it money management or risk management, the meaning is one and the same.
When you start trading without having an understanding of how to manage your risk, chances are that your profits will diminish over a period of time.
This is probably one of the reasons why many retail traders lose money trading forex.
Only a few make the cut.
Being over leveraged, letting the emotions dictate the terms of trade are just one of the many ways’ traders end up losing money in forex.
Despite making profits at regular intervals, trading without managing your risk can be disastrous over a period of time.
Once you hit a string of losses, the situation can get from bad to worse.
Recovering from losses in forex trading is an uphill task. And being able to climb this uphill can be even more difficult if you end up trading without a proper risk management strategy.
To illustrate this, let’s take a simple example. If you started with a trading capital of $10,000 and lost 20% of your capital, you are down to $8,000. In order to recover this 20%, you will need to ensure that the next trade or set of trades you take will bring you back to the original starting capital of $10,000.
What you can see from the above is that every time your trading capital falls by a certain percentage, it takes twice the effort to make up for the losses and to turn a profit.
When you are in a losing streak, you can end up continuously losing your capital until it gets to a point that you would not be able to recover strongly.
Should you be taking risks in forex?
The answer to this is yes. Although forex trading might sound lucrative, the fact remains that speculating is a risky business.
John Maynard Keynes, the famed economist once said that the markets can remain irrational, longer than you can remain solvent. This couldn't be further from the truth.
However, most traders tend to focus on the other aspects. Hopes that the market will turn around and nurturing their losing trades is one of the classic traits that one can find among retail traders.
The fact remains that without taking risks in the financial markets, including forex, you won’t be able to make any profits. Generally speaking, the rule of the thumb is that investors or traders expect to see higher returns when they are taking on the risks.
While this means that taking risks is an essential aspect of trading, traders need to be also aware of managing these risks. Most traders don’t take too nicely to losing trades. They end up letting their emotions taking over their trading.
This can lead to bigger losses when trading.
While risks are essential to make a profit, the risks also need to be managed properly so you don’t end up losing your money for the sake of taking risks to churn a profit.
Most smart people including successful businessmen take a lot of risks. Without risks, you cannot expect to gain any rewards.
However, the risks taken by these businessmen are also well managed.
How to get started with managing risk in forex?
So far, we spoke about the aspects of risk and how it influences your trading. Managing risk in forex is an essential aspect and is just as important as your trading strategy.
A general rule of the thumb is that traders should not risk more than 2% of their trading capital on any given trade. However, this is applicable only if you have a trading capital that is upward of six figures. Most retail traders tend to make a deposit of $1000 or higher.
Under these circumstances, risking 2% of your capital can quickly erode your trading capital and can burn a hole in your pocket.
The first step in risk management is to ensure that you are adequately capitalized. If you think you can turn a profit by depositing just $500 and hope to double this amount, then you have already made the first mistake even before you started trading.
Risks in forex happen because of unrealistic expectations. Traders expect to make 10% and even 20% returns every month. While this is possible, it requires a lot of skill and experience in the markets. Having a more realistic expectation can help you to remain patient and trade more effectively.
This is where the deposit amount or your trading capital plays a big role. Obviously, a 5% or even a 1% return varies between a capital of $500 and $50,000.
The next aspect is leverage.
Without leverage, there is no possibility for you to trade forex unless you are well capitalized.
However, most retail traders cannot afford that amount of money. Therefore, leverage is the next option that traders choose.
Thanks to recent legislations and rules, there are now limits on the amount of leverage that you can use.
Earlier, traders were able to choose leverage as high as up to 1:1000. This is often the case when you are inadequately capitalized. When you have a decent trading capital, having a leverage of less than 1:100 is more than enough.
Leverage, which is used to magnify your profits can also work against you. Leverage in forex simply allows you to maximize your positions. This in turn allows you to make huge profits without having to put up a large capital.
But at the same time, leverage can also be disastrous as it can lead to strong losses and could potentially wipe out your capital.
Therefore, the first step to risk management is to have the right amount of trading capital and the right leverage.
Dealing with emotions when trading forex
Like it or not, humans are emotional beings.
Therefore, when trading it is not uncommon to find that emotions can dictate the terms of your trade.
If you have been trading for even a little while you can certainly notice the high that you get when you have had a series of winning trades. These back to back winning trades can boost your confidence. While this is good, it can also push you to take on more risk that you wouldn’t otherwise.
Similarly, when you hit a series of losing trades, your confidence takes a hit. This can lead you to take on less risk and thus lower your rewards.
So the question is how can someone deal with their emotions when trading forex and find a balance?
The trick is in finding a balance.
One of the reasons why risks can magnify when trading forex is that retail traders tend to overtrade most of the times. This can happen for a number of reasons. One trader might be chasing unrealistic returns, while another trader is trying to make up for their losses. Another trader might have taken a string of winning trades and feels invincible and continues to prolong the number of winning trades.
Regardless of the reasons, overtrading is a real issue when it comes to forex trading and risk.
A good way to deal with this is to ensure that you set your daily limits. The daily limits could be the daily returns and your limits for losses.
Once you hit either of these thresholds, you should stop trading for the day or the week.
Following this stringently can enable you from overtrading and will also allow you to take some time off from the charts.
Managing your winning streak or recovering from a losing string of traits requires a bit of discipline and effort. You can hone your discipline by firstly setting a daily, weekly and monthly targets. Once any of these targets are set, you can stop training and allow yourself to be reset.
Forex risk management books
Risk management is such a vast field that there have been many books written about it. You can find books ranging from how to effectively manage risk by managing your trades to trading psychology. Here are some of the forex risk management books that will certainly benefit you.
The Essentials of Risk Management - Volume 2
This book, authored by Michel Crouhy, Dan Galai and Robert Mark gives a broad overview of the important of risk management. The book gives you insights into how to quantify risk and returns and includes the innovations in risk management since the 2008 financial crisis.
The authors are well known professionals in their fields and includes an academic perspective of risk management and combines practical advice from the industry as well.
The book basically covers the risk management aspect of the banking sector. However, as traders it provides valuable insight into how risk management is at the heart of the financial institutions. Given its importance, it is not surprising that this is a book that traders should start off with to truly understand the importance of risk management.
Risk Management for Forex Trading Beginners
Authored by J.R. Bosanko, Risk management for forex trading beginners the next book that you should read if you want to learn more about how to manage risk.
The book provides a smooth learning curve into risk management for beginners to forex trading. However, this book is not applicable just for beginners but also for experienced forex traders.
It provides insights into how the smart money operates and gives you a list of do's and don'ts when it comes to risk management techniques in trading forex.
Trading in the zone
Mark Douglas, the author of Trading in the zone: Master the market with confidence, discipline and a winning attitude is one of the best selling books when it comes to forex risk management.
This book, which is highly recommended gives insights into the various trading perspectives such as psychology and having the right mindset to developing your own trading plan.
There is a good amount of detail dedicated to understanding the true realities of risk management and provides the groundwork for identifying the probabilities of the market movement.
Mark Douglas' trading in the zone is a highly recommended book that is a must read if you are trading forex.
Forex risk management – conclusion
To conclude, forex risk management is often brushed aside by traders but in reality, risk management is one of the key elements towards preserving your trading capital. Most forex traders lose money due to the simple fact that they immediately focus on building a trading strategy but pay little attention to how to manage risk.
In this article, we covered the various aspects that a trader should look out for; such as the trading capital, using the right amount of leverage and having the right mindset. You cannot master risk management just by reading this article or by reading a few books.
The best way to be adept in managing risk while trading forex is to put your knowledge into practice. Being patient and continuously striving to manage your risk better rather than focusing on how much profits you made is a good starting point when it comes to managing risk in forex trading.
At the end, it is important to note that forex trading is in itself a risky business. Given the fact that the word risk is part of the forex trading game, more focus should be paid on how you can manage this risk.