ACTUAL FOREX TRADING
BECOME A PROFITABLE FOREX TRADER
Forex Risk Management Explained
Two keys to becoming a successful trader are:
1. Trade a profitable strategy
2. Minimise risk
This post will teach you everything about Forex risk and money management.
'Trading with high risk can result in temporary high returns, but ultimately, it 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'
Risk & Money Management - A Key to Successful Trading
Embarking to become a profitable Forex trader is a formidable task. It's a path that many brave yet often find themselves stumbling upon. The reasons for these setbacks are not unique to you but rather a shared experience among many. These common hurdles include:
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
While this site covers various aspects of Forex trading, this page is dedicated to the last point mentioned: risk and money management. This topic is of utmost importance and relevant to your Forex trader journey.
Risk Management 101
When trading Forex, there is much risk. Whenever there is the possibility of financial loss, there is financial risk.
The best traders manage, control, or even eliminate trading risk. I once heard a professional trader once say, 'my job is all about reducing risk. Nothing else!'.
The best way for me to explain trading risk is to compare trading to gambling. Comparing the two will help you better understand risk management and why it is needed when trading:
Comparison #1 - Gambling is a game of chance
The main difference between gambling and trading is the ability to control risk. Gambling, often a game of chance, offers little to no control over risk. In contrast, trading empowers individuals to manage and control risk, making it a strategic endeavour.
Those who gamble put their faith in chance. 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. However, in trading, the risk of losing money is not left to chance; rather, it depends on a well-thought-out strategy. While the results of a trading strategy may seem random, each trade is driven by logic, not chance. This logic is often based on extensive technical and/or fundamental analysis for entry and exit. The trade is meticulously thought about, planned, studied and analysed in great detail, providing a sense of security and control that gambling often lacks.
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 you gamble, it's a game of chance where you either win big or lose it all. For instance, if you bet on red and the ball lands on black at the roulette table, you lose your entire bet. However, trading and investing are different stories. Each position you take can appreciate or depreciate, depending on the market conditions. Your investment is not a one-time win or loss but a continuous process that mirrors the market's movements.
Understanding risk management is crucial in trading and investing. Unlike gambling, where bets are often all or nothing, trading and investing are about diversifying your positions. Putting all your money on a single trade is risky and can lead to significant losses. Instead, it's advisable to spread your investments across different assets, reducing the potential impact of a single investment's performance on your overall portfolio.
Can trading be gambling?
Yes, it can. Those who don't implement good risk management are pretty much gambling. They bet on the market as they place trades without any clear risk or trading strategy. There is little difference between choosing to go all-in on randomly buying EURUSD and going all-in during blackjack.
Money Management 101
Money management and risk management are closely connected. Most traders use the terms interchangeably.
Risk and money management include:
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Position sizing - how much you risk per trade
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Account exposure - how much of your trading balance is at risk at any given time
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Brokers - trading with a broker that provides a reliable trading experience and safety for your trading funds
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Strategy - following a detailed trading plan or system
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Risk-reward ratios - ensuring that losses are small and winners are big
All of these points will be covered further later on this page.
Risk Management and Trading Emotions are good friends - they like each other's company!
Trading emotion and psychology are often directly connected to risk and money management.
Emotions can be intense when trading. They can lead a trader to divert from their trading strategy, ultimately leading to losses and failure. The less strict we are with risk management, the more intense these emotions are. In other words:
Loose risk management = more intense trading emotions
Strict risk management = lesser trading emotions
As you can see from the above graph, the more you risk (x-axis), the higher the trading emotion (y-axis).
To emphasise this further, let's explore real-life scenarios highlighting the direct correlation between risk management and emotional decision-making in trading:
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Consider a trader who risks too much per trade due to poor risk and money management. As a result, their account balance plummets after a series of losses. Frustrated, they deviate from their trading strategy, hoping to recover their losses. This decision, driven by emotion, often leads to further losses and a cycle of frustration.
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Another trader decides to risk too much per trade. His first trade is in profit, much profit. The trader fears price reversing and losing the significant floating profit, so he diverts from the strategy and closes the position too early. This leads to short-term relief but long-term frustration, as the strategy will under-perform.
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A trader is frustrated with her performance. She becomes impatient and frustrated, opening all sorts of illogical, false hope trades. She loses and becomes even more frustrated.
The lack of risk management allows the trader to trade on emotion in each of the above examples.
If you struggle with your trading emotions, the most effective solution is to enforce stricter risk management. This disciplined approach can help you avoid impulsive decisions and risking too much per trade, and maintain a more rational trading strategy.
'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 previously highlighted, the absence of risk management often leads to heightened emotional trading. This can lead to many undesirable outcomes, underscoring the crucial role of strict risk and money management.
Understanding and applying risk management rules can help to:
1. Mitigate trading fear. A disciplined approach to risk management can significantly reduce trading fear. By avoiding excessive risk per trade and managing losses, traders can prevent emotional barriers that hinder trading or lead to impulsive, emotional trading.
2. Preserve trading capital. Uncompromising in your risk management rules should allow you to keep trading, even after losing days, weeks, or months. It helps traders ensure their losses are always small, avoiding blowing their trading accounts.
3. Increase their chance of success. Traders who are less emotional and can preserve trading capital have a much higher chance of success.
4. Cultivate a professional image and mindset. Mastering risk management is non-negotiable if you aspire to trade for a fund or manage other people's money. Earning a living from trading or gaining acceptance from trading funds hinges on demonstrating a profound comprehension and unwavering commitment to managing and controlling your Forex trading risk.
The Best Forex Risk Management Strategies
So, what are the best strategies for Forex 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 managing and reducing risk when trading Forex.
Strategy One: Stop Losses & Take Profits
This may be too simple and obvious for most of you, but I must 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 logical and part of your trading strategy.
Strategy Two: Position Sizing
This is a biggie. Most new traders who are emotionally trading or blowing trading accounts are simply risking too much per trade. Their lot size is too significant for their account balance.
All traders must adhere to a risk percentage per trade, ideally ranging from 0.1% to 0.5%. Remember, the lower the risk, the better the chances of preserving your trading account.
Use a position size calculator to ensure you're calculating your position size accurately. This tool will guide you on the appropriate lot size for your trades.
If you are using low leverage, you must always have sufficient margin to meet margin requirements. I suggest using a margin calculator.
Strategy Three: Risk Reward
All potential rewards should be more significant than potential risks. In layman's terms, your take-profits must be wider than your stop-losses.
By adhering to this strategy, you are in control each time you enter a trade, ensuring that:
1. A stop-loss has been set
2. That winners are always bigger than losers
Even though risk-to-reward doesn't directly help reduce risk, it does help manage your account balance and add more logic to your actions.
Risk reward is usually expressed as a ratio of 1 risk to the potential reward. For example, 1:3 is one risk to three reward.
Strategy Four: Account Balance
If you fund an account with more than you are willing to lose, you risk too much.
The entire account balance with your broker is always at risk, especially if you are trading without strict position sizing and using high leverage. Only fund what you are willing to lose, as there is a chance you will lose it all!
Strategy Five: Broker
Forex brokers can go bust. It happens. If you're prepared, you can retain your valuable trading funds.
By funding your trading account with only 30-50% of your actual available trading funds, you are effectively reducing your exposure to your broker. This prudent approach, especially when trading on leverage and risking less than 1% per trade, empowers you to meet margin requirements without overexposing yourself to the possible collapse of your Forex broker.
It's crucial to trade only with well-regulated Forex brokers. This ensures the safety of your funds and provides a sense of confidence in the broker's financial security, leading to a much more positive trading experience.
Trading with an FCA-regulated broker protects capital through the FCA compensation scheme of up to 85,000 GBP.
If you are looking for well-regulated brokers, I highly suggest IC Markets (ASIC) or Darwinex (FCA).
Strategy Six: Leverage
Leverage is amazing. It helps you make significant returns even with the smallest trading accounts. I love it. However, having too much leverage drastically increases trading risk.
Having access to high leverage does not inherently make trading more risky. However, using high leverage allows traders to make trading more dangerous if they desire to. The ability to overtrade and have too high position sizing is much easier with higher leverage.
High leverage means a trader can drastically increase lot size and overall market exposure. Whereas lower leverage automatically reduces the limit of risk a trader can take.
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!
Strategy Seven: Market Gaps
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 the price is near your current stop-loss.
It is also prudent to adopt this risk strategy with high-impact news events.
Strategy Eight: High-Impact 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!
Strategy Nine: Have a Detailed Trading Strategy
Your trading strategy should detail your risk and money management plans and rules. Follow these rules.
Martingale trading is not a good trading strategy. It 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. Stay away!
Strategy Ten: Currency Risk
Having too many positions open that are exposed to the same currency increases risk. Ensure you are not overly exposed to a single currency at any given time.
Being long or short, multiple currency pairs that are positively correlated can lead to various losses. For example, being long AUDCHF, AUDJPY, and AUDUSD means you could lose three trades if the AUD falls.
An excellent way to combat currency exposure is to cherry-pick trades when potentially multiple trades are correlated or reduce position sizing when opening various positions of the same currency.
Summary
In summary, be a professional trader, not a gambler. Be sensible, do your research, and be smart.
Listen to my podcast episode on Forex risk management by clicking on the box below.