Your Ultimate Guide to Forex Risk & Money Management - Forex Risk 101
There are 2 keys to becoming a successful trader; trade a profitable strategy and minimize risk.
In this post, I will teach you everything I know about risk and money management and how to apply this to Forex trading.
'Trading with high risk can result in temporary high returns, but ultimately will lead to large losses and blown trading accounts... Those that trade with high risk are generally trading on emotion; they are being impatient or greedy...'
Becoming a profitable Forex trader is not easy. Almost all who try to make money from trading financial markets end up failing. The common reasons why most traders fail are...
1. Not having a profitable trading strategy
2. Having a profitable strategy but not following it due to the challenges of trading emotions and trading psychology
3. Not protecting capital by trading with high risk i.e. A lack of risk and money management
This site has various content for all 3 points mentioned above. This page is specifically for the last of the points though; risk and money management.
Risk & Money Management - a key to Successful Trading
Risk Management 101
When trading Forex, there is a lot of risk. Your account balance you hold with your broker is at risk and the money you use to enter each trade is at risk. Whenever there is the possibility of financial loss, there is risk.
The best traders manage, control or even eliminate trading risk.
The best way for me to explain trading risk is to compare trading to gambling. Comparing the two will help you to better understand what risk management is and why it is needed when trading...
Comparison #1 - Gambling is a game of chance
The main difference between gambling and trading is the element of being able to control risk. Gambling has little to no ability to control risk, whereas trading is mostly about controlling risk.
Those that gamble put their faith in chance. In fact, the accumulation of most gambling wins and losses is the result of chance. It's the luck of the dice, the luck of the cards or the luck of the roulette wheel.
When gambling, the risk of losing money depends on chance. When trading, the risk of losing money depends on strategy. It's true that the results of a trading strategy are random - any given trade could be a winner or a loser - but logic is the driving force behind each trade, not chance. This logic is often based on extensive technical or fundamental analysis for both entry and exit. The trade is thought about, planned, studied and analysed in great detail. Placing your money on red or betting on the deal of the cards is often not.
Two risk management points you need to learn are...
1. Trades should be based on logic, not chance. You need to have a clear trading strategy that provides an edge.
2. Trades should be well planned and studied, not traded on gamblers hope.
Comparison #2 - Gambling is all or nothing
When gambling, the money placed on any bet is either lost in full or returned with winnings i.e. All or nothing. At the roulette table, placing your money on red and the roulette ball lands on black means your whole bet is taken by the house - it's all gone! Whereas when trading and investing, each position either appreciates or depreciates in value, it's not all or nothing - your position will rise or fall in value with the market price - it's an investment, or at least a speculative investment.
Another risk management point you need to learn is... Trades should never be all or nothing!
Can trading be gambling?
Yes it can. Those that don't implement good risk management are pretty much gambling. If they risk everything per trade and/or take trades randomly without clear strategy, then they are simply gambling the market - there is very little difference between choosing to go all-in on randomly buying EURUSD than there is going all-in during black jack.
Money Management 101
Money management and risk management are closely connected. Some traders even use the terms interchangeably.
I tend to define money management as part of risk management but more focused on the cash side of risk. Money management generally refers to principles such as position sizing, account balancing and depositing with brokers. Risk management covers these things also, plus the non-cash side of risk, such as strategy, currency exposure and risk reward ratios.
Risk Management and Trading Emotions are good friends - they like each others company!
Trading emotion and trading psychology are often directly connected to risk and money management.
Emotions when trading can be intense. They can lead a trader to divert from his or her trading strategy, which ultimately leads to losses and failure. These emotions are usually more intense the less strict we are with risk management...
Loose risk management = greater trading emotions
Strict risk management = lesser trading emotions
Let me give you some examples that demonstrate the link between risk management and trading emotion...
A trader decides to risk too much per trade i.e. They have poor risk and money management. After a few losses, their account balance has declined significantly. They become frustrated, so they start taking trades that do not fit their strategy, in the hope of gaining back what they have lost.
Another trader decides to risk too much per trade. His first trade is in profit, a lot of profit. The trader becomes fearful of price reversing and losing the large floating profit, so he decides to divert from the strategy and close the position too early. This leads to short-term relief and satisfaction but long-term losses and frustration.
A trader is frustrated with her performance. She becomes impatient and frustrated, so she starts opening all sorts of illogical, false hope trades. She losses and becomes even more frustrated.
In each of the above examples, the lack of risk management allows the trader to trade on emotion.
If you are struggling with your trading emotions, then perhaps the answer is to implement stricter risk management.
'Good risk and money management allows a trader to take consecutive losing trades and still have the necessary capital to keep trading... It also allows a trader to have consecutive losing trades without becoming emotional'
Why you need to be Strict with Risk Management
As mentioned already, a lack of risk management often leads to greater emotional trading. There are many reasons why strict risk and money management should be used though...
1. A reduction in fear. A lack of risk management often leads to increased trading fear. Risking too much per trade and then having a few losing trades can cause an emotional block that stops a trader from trading or can lead to more extreme emotional trading.
2. A preservation of trading capital. Being uncompromising in your rules for risk management should allow you to financially keep trading, even after losing days, weeks or months. It helps traders to avoid blowing trading accounts and ensures that losses are small.
3. An increased chance of success. Traders that are less emotional and are able to preserve trading capital have a much higher chance of being successful.
4. Creating a more professional image and attitude. If you are serious about trading and want to be able to trade for a fund or with other peoples money, then risk management is something that you have to master. Making an income from trading or being accepted by a trading funds is only possible if you can demonstrate a deep understanding and consistent commitment to managing and controlling your trading risk.
The Best Risk & Money Management Strategies
So, what are the best strategies for risk and money management? How can you better control your trading risk and plan for money management? Below are my top tips, trading plans and strategies for controlling, managing and reducing risk when trading Forex..
Stop-losses & Take Profits
Okay, this may be too simple and obvious for most of you but I had to mention it...
Using a stop-loss allows you to limit your risk per trade and avoid the pitfall of holding onto a losing trade for too long.
Using a take profit gives you a goal to aim for and helps to ensure you have set a healthy risk reward ratio.
Of course, all stop-losses and take profits should be totally logical and part of your trading strategy.
This is a biggie. Most new traders that are emotionally trading or blowing trading accounts are simply risking too much per trade. Their lot size is just too big for their account balance.
All traders should be risking anywhere from 0.1%-2.0% per trade, no more. The less you can risk the better.
To calculate your position sizing correctly, you will need to use a position size calculator. This will help to determine what lot size you should be using. I suggest using this one by myfxbook.
If you are using low leverage, you will need to ensure that you always have sufficient margin to meet margin requirements. I suggest using a margin calculator. I suggest this one also by myfxbook.
All potential rewards should be larger than potential risks.
Following this strategy each time you enter a trade ensures that...
1. A stop-loss has been set
2. That winners are always bigger than losers
Though risk to reward does not directly help to reduce risk, it does help to manage your account balance and add more logic to what you are doing.
Risk reward is usually expressed in ratio of 1 risk to the potential reward. As an example, 1:3 being 1 risk to 3 reward.
If you fund an account with more than you are willing to lose, then you are risking too much.
The full account balance with your broker is always at risk, especially if you are not being strict with position sizing and using high leverage. Only fund what you are willing to lose, as there is a chance you will lose it all!
There is a chance that your broker could go bust, another reason to only fund your account with what you are willing to lose.
Funding your trading account with only 30-50% of your actual available trading fund helps to reduce your exposure to your broker. If you are trading on leverage and only risking around 1% per trade, then 30-50% should be enough to meet margin requirements.
Only trade with Forex brokers that are well-regulated. This can help to ensure that funds are safe and that the broker is financially secure. It may also help you to have a much better trading experience.
Trading with a broker that is FCA regulated protects capital through the FCA compensation scheme of up to £85,000.
If you are looking for well-regulated brokers, I highly suggest IC Markets (ASIC) or Darwinex (FCA).
Leverage is amazing. It helps you to make large returns even with the smallest of trading accounts, I love it. Having too much leverage drastically increases trading risk though.
Leverage will not inherently make trading more risky. But using high leverage allows a trader to make trading more risky if he or she desires.
High leverage means that a trader can drastically increase lot size and overall market exposure. Whereas lower leverage automatically reduces the limit of risk a trader can take.
Having a leverage of 1:30-1:100 should be more than adequate when trading Forex. IC Markets allows you to choose your leverage as high as 1:500, so please be careful!
The Forex markets can sometimes gap significantly over the weekend. This can lead to trades being stopped-out well above or below the set stop-loss price. Resulting in larger losses than intended.
To prevent this, try to close positions over the weekend - or at least reduce position sizing - if price is anywhere near your current stop-loss.
The same with major economic news events - trade around them or reduce position sizing.
Some news events - such as interest rate announcements - can create too much volatility and market movement, especially for day traders. Sometimes it's best to stay out!
Your trading strategy should detail your risk and money management plans and rules in detail. Follow these rules.
Just so you know, martingale trading is not a good trading strategy. This involves doubling-up or increasing your position size after every losing trade. Basically, increasing your risk after every trade... A recipe for trading disaster! Grid trading is similar.
Having too many positions open that are exposed to the same currency increases risk. Ensure that at any given time, you are not overly exposed to a single currency.
Being long or short multiple currency pairs that are positively correlated can lead to multiple losses i.e. Being long AUDCHF, AUDJPY and AUDUSD means that you could have 3 losing trades + if the AUD falls.
A good way to combat currency exposure is to cherry pick trades when there are potentially multiple trades which are correlated or simply reduce position sizing when opening multiple positions of the same currency.
In summary, be a professional. Be a trader, not a gambler. Be sensible. Do your research. Be smart.