Risk Management in Forex Trading

Most traders downplay the importance of risk management, as they believe that in order to be a successful trader, it’s all about finding a great methodology of entering a trade, and they will spend 95% of the time on how to enter their trades and only 5% on how to get out of them. Speaking from my own experience, what I have found is that traders who are really successful worry much more about how they’re going to get out of their trades without losing too much and conserving their capital, than they worry about making the money. Successful traders are much more concerned about not losing money than they are about making money.   This means that risk management is more important than the entry method for any trades.

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So, as you may guess the difference between a successful trader and one who loses everything is rarely defined by luck, but rather the contrary.  The successful trader will approach each trade with the precision of a professional sniper trying to predict each and every possible mishap and trying to take every step to avoid it. In Forex trading this boils down to three basic elements:

  1. Know your currency pair;
  2. Know your limitations;
  3. Set a win to loss ratio;

1.    Know Your Currency Pair

One of the most overlooked aspects of risk management is knowledge. Knowledge will make your trading activity less risky because the more knowledge you acquire, the more skilled you become – where your trading activity will become less based on luck and more on experience. Like the circus performer who makes tightrope walking seemed easy, knowing what to invest in, when, and how much is the result of hard work. Before investing in an asset, research it. The same computer you place trades with can be used to search for information. Look for news items that can have an impact on your trading, try to gauge market sentiment, open some historical charts and check out how the currency pair has reacted in the past to various events.

Before entering a trade look at the present charts and see how the currency pair is reacting to the day’s news, try to define whether your currency pair will rise or fall and at what price you should open a position. Take a good look at current market fluctuation and set your stop loss and take profit orders accordingly.

2.    Know your limitations

Leverage is a wonderful tool, as without it, you probably wouldn’t be here.  You’d never have been able to mobilize cash necessary to make a noticeable profit from Forex trading in the first place. On the other hand never invest more than you can afford to lose.  Most professional traders never risk more than 2%-3% of their equity. In order to accomplish that, you have to calculate your trade volume taking into account the leverage loss you could take at any point.

3.    Set a win to loss ratio

In terms of your risk to reward ratio, you always have to look to have more reward than your risk. The idea behind effective trading is that you’re always risking less than you can potentially make.  However, there is no exact ratio you can follow because it changes depending on the length of the trade that you’re taking on and the type of instrument you’re using.   So you just need to have a look at the price ranges, the volatility that exists in the market (which is how much the price can move over the time that you want to trade) and from that you can create your own ratio for every trade. But, ideally, we need to minimize risk as much as possible and try to maximize the profits and that is done through a proper risk to reward ratio.

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Source: DailyFX

Note that no strategy wins all the time and when you’re trading you’re going to have trades that lose, and you’re going to have trades that make a profit.  The trick is to make more profit from those winning trades compared to your losses from losing trades. One of the largest US retail Forex brokers, after studying millions of trades made by their clients, has reached to the found that even though their retail traders were more often right than wrong they were still losing money.  They concluded that the sole reason why traders lose money over the long haul is that “they lose more money on their losing trades than they make on their winning trades.

3.1.       Risk of Ruin

The risk of ruin refers to the probability that you’ll lose all your trading capital. Suppose you throw a coin, heads you win and tails you lose, the probability of losing is 1 of 2 outcomes or 50%. If your trading capital is $10k and you risk it all on one trade, then the risk of ruin is 50%. Let’s take it one step further and assume you’re going to risk 5% on every trade and bring in both the concept of risk of ruin and the risk to reward ratio into the example (see Figure 1 below).  You will see that the higher our risk to reward ratio is, the less winning percentage we’ll need to survive in the Forex trading business.

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Figure 1: Risk of Ruin Table Example – Risking 5% of equity per trade

4.    Conclusion

Forex trading is not a moneymaking business,  a market-prediction business or even a part of the finance sector. I think the most important thing to understand about forex trading is that Forex traders are all in a risk management business, and we have to think of ourselves as a company that manage risk, and thus our guiding principle should be our risk to reward ratio.  The higher our risk to reward ratio is, the bigger the chances are that we will survive in this business with continued growth in our capital base.