13 mins read
The forex market is one of the world's largest and most liquid financial markets. Traders in the forex market trade more than 5 trillion dollars daily, which translates to more than $220 billion an hour. This opens up many opportunities for experienced and novice traders to make profitable trades.
With much money to profit from the forex market, it is not uncommon for people to place multiple daily trades while looking to gain profits. This is all good, but making the wrong choices while trading can expose you to lots of risks. And with the lack of risk management, you can lose all your capital if you make the wrong trades.
Professional traders know how to mitigate risks so that it doesn’t affect their portfolio. If you are a novice or intermediate trader, you may need to find ways to reduce the exposure of your account. Luckily, we outline the different strategies that will help you manage risks while trading. But first?
What is Risk Management in Forex?
Forex investors are in the business of making money, which makes it prudent for them to minimize any potential losses. Unfortunately, most forex investors never consider risk management when choosing their trading strategies. They just come up with several that they are willing to lose and start trading. But trading without risk management is gambling since you just want a big win without caring about your capital.
With a risk management plan in forex, you take action to protect your investment from potential losses. You should note that high risk may mean higher returns, but this also means that you stand to lose the most. The best skill a trader can invest in is to minimize any risks and maximize profits.
Forex risk management allows you to set up trading rules and measures to offset improper market movements. That said, you will have to make plans for a few months or weeks before you start trading. Implementing these risk management strategies well is the surest way to ensure you have a profitable trading experience. Don't miss our detailed analysis of Forex.com Trading Platforms.
Risks of Forex Trading
You don’t just risk your capital when trading forex blindly. There are several other risks that you should also consider before coming up with a risk management strategy. Here are some of the risks of forex trading.
Interest rate risks– Market fundamentals may be okay but are likely to be affected by changes in interest rates. Any sudden reduction or even increase in interest rates will affect market volatility. Interest rates affect the level of spending, saving, and even investing in a country depending on whether they go up or down. Be keen on interest rate changes if you want to mitigate FX risks.
Leverage risks- This is the risk of having magnified losses when you take up a lot of leverage. Leverage in forex allows you to magnify your investment but this exposes you to either magnified profits or losses. You only need to invest a little capital, and your broker will give you some high leverage so that you can trade effectively. It is easy to forget about leverage risks but it can cause serious damage to your financial health.
Currency risks– In some instances, you will face some currency risks when prices and the value of currency pairs are shifting. The effect is that you will either have to buy currency pairs cheaply or more expensive.
Liquidity risks– Liquidity issues arise when you are unable to buy or offload a currency pair fast enough to prevent unwanted price movements. And while forex is one of the most liquid markets in the world, there are times when you may find some liquidity problems. However, this depends on the type of currency and whether there are government restrictions surrounding its trading.
How Much Risk Is Too Much Risk?
Anyone who has traded in the forex market knows that it is almost impossible to predict market trends and currency price movements. Some major or even minor news can shift market prices in a certain direction. In other cases, an institutional investor or a whale’ can pump in some significant funds that will change market patterns.
So, you will have to think about your risk even with the best trading strategies. A lot of experts and conventional market norms require that you risk 1% to 3% of your capital when trading. And while this is somewhat the general rule, it may be different for everyone.
For instance, you may choose the 1% risk exposure when investing $5,000 but this only means that you can invest $50 for every trade. If this is insufficient for you, you will likely increase your risk exposure and endanger your position. This does not mean that you should disregard the conventional advice but stick with something comfortable for you within that range.
You must also stick to this risk percentage in all your trades. You cannot make 5 trades with a 2% risk exposure and make 7 more with a 5% risk exposure. This will likely end up with you losing money.
Just pick a risk percentage that you are comfortable with (within the 1 to 3% range) and stick to it no matter what.
Risk Management Strategies in Forex
Being profitable in forex requires you to have the right trading strategies. Controlling your losses is one of the ways to ensure that most of your trades are profitable. The good thing is that we have compiled several risk management strategies in forex so that you can make more profits. These are some of the strategies that can help you reduce risk.
Get a comprehensive understanding of trading the FX market
You may be a good investment when it comes to equities but the forex market is different. Stocks may take some bit of time before you realize some gains or losses but currency trading is much more volatile and prices shift every second. This is why every forex investor, especially newbies, should have a good understanding of forex basics.
Professional investors should also keep learning and staying updated with market trends. Learn how to read charts and predict market trends. Read up on forex market theories such as the Elliott Wave Theory, and find out how you can use indicators to increase profitability.
Getting the right knowledge and skills is invaluable in any industry and will do a lot for your trading career. You can find a lot of useful and accurate information about the forex market when you look online.
Watch out for leverage
High leverage sounds like a great idea, especially when you are a beginner. You stand to make a lot more money with leverage as opposed to only trading with your funds. What most people find out too late is that they also stand to lose more when they use high leverage. But what exactly is leverage?
In forex, one uses leverage when they trade with borrowed capital from the broker. A forex broker can give you leverage when trading currencies or CFDs whether you are a retail or an institutional investor. This means that you will be able to trade a large position with a relatively small deposit. Once you close a leveraged trade, the money advanced to you goes back to your financial broker while you get to take the profits or suffer the losses.
A forex broker who offers a 1:400 leverage means that you only need to invest a thousand dollars to open a trade worth $400,000. You will get profits if you predicted the price movements well but may also suffer magnanimous losses should the market go against you. This means that your risk exposure increases significantly with high leverage. Limit your leverage use or only use it when you understand the potential losses you face.
Come up with a profitable yet realistic trading plan
Yes, you have seen all the online videos of traders making millions out of the forex market. And may even want some part of it. But this does not mean that you should take senseless risks just to get insane profits. Having unrealistic expectations is one of the fastest ways to make losses in forex.
Trading aggressively may seem like the best idea at first but it just increases your risk exposure. Of course, you may make a killing on one or two trades but you are bound to get burnt on some of the trades you make. The best forex traders know that getting steady returns is the only way to stay profitable and this can mostly be done by remaining realistic.
It is worth noting that part of being a realist is admitting when you are wrong or when you make a wrong trade. Many people will try to salvage a wrong situation by opening more trades to recoup their losses, which is very human. But it is likely to make you jump from the frying pan to the fire.
Having realistic expectations will also prevent greed, which is a serious problem for forex traders. Remember that you do not need to open trades every other time just to be profitable. A realistic plan will ensure you trade at the right time and make profits with little to no risk.
Set a risk-reward ratio
Despite having a good amount of leverage, you need to mind the amount of capital that you risk trading with. In the long run, you want to have more of your trades running into profits as opposed to losses even if you lose on some individual trades. One of the best ways to reduce risk in forex is by setting up a conservative risk-reward ratio.
What exactly is a risk-reward ratio when it comes to trading forex? Well, this is simply the amount of money that you trade with but it is made as a percentage or ratio. If you are new to trading or have a low-risk tolerance then you can have a low-risk percentage. Trading 1% of your capital is not such a bad risk percentage when you are still new to forex. As a general rule, professionals can trade up to 5% of their capital if they have a risk appetite.
To see the impact of risk-reward percentage on trading, take for instance three traders with a trading capital of $10,000. The three forex traders decide to take on 1%, 3%, and 10% risk respectively, which means that each trader will have to risk trading with $100, and $300 and the last person uses $100 per trade. On a losing streak of about 10 trades, the person with a risk-reward ratio of 10% is likely to have lost their account balance by more than 70%.
A good risk-reward ratio allows you to reduce risk and trade comfortably even when you are on a losing streak. Just set the right ratio and stick to it.
Be mindful of stop losses and take profit orders
Another common mistake that traders make is avoiding the use of a stop loss when incurring losses or a take profit when there are significant gains. This is not uncommon since many traders wish to reverse losses when their account is all red and may avoid taking a loss, which leads to further losses or a margin call. We recommend you to check our IC Markets Account Types and Trading Features review.
An order is an instruction that you make to your broker to place a trade when the price of a currency pair hits a certain level. A stop-loss order will help prevent further losses while a take-profit order guarantees that you lock in a certain amount of profit. Here are some reasons to use these orders
- It protects your downside when making losses to ensure you do not blow your account.
- Gives you peace of mind to allows you to do other things when trading
- Helps you align your risk management strategy to your trading plan
Manage your emotions
Perhaps one of the least talked about strategies of trading forex is knowing how to manage your emotions. Trading forex will give you a roller coaster of emotions. You will feel on top of the world when making back-to-back profits but you can also have a depressive moment when taking losses.
If you let emotions cloud your judgment when trading then you are likely to struggle with sticking to rules and trading strategies. You may find it difficult to leave the forex market when you make losses but waiting for that will mean you will end up losing more capital. Alternatively, you can also have a winning streak and get too cocky by not using your take profits.
Beware of local or international news and events
Many factors affect the price movements in forex and you should beware of all of these when trading. Predictions on these shifts can be quite difficult since market fluctuations are caused by numerous factors. Novice traders can keep updated with the market by following CBK announcements, political news, and the news on the economic outlook of major currency countries.
For example, many central banks around the world have a monetary policy committee that decides on banking interest rates. Keeping up with such news can help you figure out how a currency pair will shift and anticipate these changes.
If you want to reduce risk when trading, then you align the insights that you get from the news with your trading strategy. Is it likely that interest rates will be increased? Then you know that the forex market will be less volatile.
Diversify your investments
One of the main risk management strategies is to avoid placing all your eggs in one basket. This is also the same when it comes to forex as you will also have to diversify your portfolio to reduce risk exposure. If you have a diverse portfolio, you will be safe even when one currency pair or instrument has a low value. A drop in the value of one currency pair is likely to be compensated by an increase in another.
You can also engage in futures and forward trading if you are done with spot trading. Futures trading allows you to legally buy or sell products at a certain time and date in the future.
Final thoughts: Managing Risks in Forex
The only way to control your trading profits and losses is by mitigating the amount of risk your account is exposed to. First, you must understand what risk means to you and the risk exposure that you and your capital can stomach. With that in mind, you will be able to set up some risk management strategies that will make you a profitable trader in no time. The right risk management strategies will allow you to trade in peace and get more profitable trades.
