Risk Management in Forex Trading

Too many traders downplay the importance of risk management.  Successful traders, who understand how to trade Forex, are much more concerned about not losing money than they are about making money.   The difference between a successful trader and one who loses everything is rarely defined by luck and rather by how they manage their exposure to risky trades, as well as understand the kind of trader they want to be.

A 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 lose ratio;

1.    Know Your Currency Pair

One of the most overlooked aspects of risk management is knowledge – where your trading activity will become less based on luck and more on experience. Before investing in a currency pair, research it.   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 check your calendar of news events to see how the currency pair will rise or fall over the coming period, 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

Professional traders never risk more than 2%-3% of their equity in a single trade. In order to accomplish that, you have to calculate the risk of the trade on your account, and stop yourself from making decisions that could set you back.  The 5 factors that will affect your risk are.

  • stop-loss measured in pips
  • pip-value, in dollar value per lot
  • position size in lots
  • equity (in dollars)
  • leverage used.

Calculating Risk in USD Value

Here is a simple calculation of risk to your account in USD value.

Calculating Equity Risk

Calculating Risk in % of Account Equity

And as a % of your account.

Calculating % Risk

Calculating Risk When Using Leverage

Leverage is a wonderful tool, but it will increase the risk on your account as you increase the leverage in your trade.  The leverage used will be included in your calculation as follows.  This example using the leverage of 1:10 as an example.

Equity & % risk with leverage

But doing these calculations, you can see where your limitations are going to be, and where the risk will be too high for your account.  Regardless of how much you believe in a trade, you will always have trades that go against you, so risk management at a trade level if very important.  That said, make sure you set a win-loss ratio that suits you.

3.    Set a win to loss ratio

A trader must have reward than risk to have success in the long term. A good trader is always risking less than they can make on a trade.  There is no exact ratio you can follow because it changes depending on the length of the trade and the pair traded.  The goal is to minimize risk as much as possible and try to maximize the profits.

win-loss-ratio-research

Average Profit vs Average Loss Per Currency Pair – Source: DailyFX

One of the largest US retail Forex brokers, after studying millions of trades made by their clients, 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.

Low Win-Loss Ratios: Risk of Ruin

The risk of ruin refers to the probability that you’ll lose all your trading capital. Let’s assume you risk 5% on every trade.  Also, let’s bring in both the concept of risk of ruin and the risk to reward ratio into the example (see Figure 1 below).

The higher the risk to reward ratio is, the less % of trades need to be won.

risk-of-ruin

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

Conclusion

Forex trading is not a moneymaking business,  a market-prediction business or even a part of the finance sector.  Forex traders are in a risk management business, and we have to think of ourselves as a company that manages risk.  The higher our risk to reward ratio is, the greater success a Forex trader will have.

Trading Forex and CFDs is not suitable for all investors and comes with a high risk of losing money rapidly due to leverage. 75-90% of retail investors lose money trading these products. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.