ACTUAL FOREX TRADING
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 you need to know about Forex risk and money management.
Jump to:
The Link Between Trading Emotions and Risk Management
Why you must use Strict Risk Management
'Trading with high risk can result in temporary high returns, but ultimately, it will lead to large losses and blown trading accounts... Those who trade with high risk are generally trading on emotion; they are being impatient or greedy'
Risk & Money Management - A Key to Successful Trading
Becoming a profitable Forex trader is a formidable task. It's a path many brave people stumble on. These setbacks aren't unique to you; many people share them. 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 focuses on the last point: risk and money management. This topic is crucial to your Forex trading journey.
Risk Management 101
Forex trading involves 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 say, 'My job is all about reducing risk. Nothing else!'.
The best way I can explain trading risk is to compare it 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.
Gamblers put their faith in chance. Most gambling wins and losses come down to 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 isn't 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 comes from 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 isn't a one-time win or loss; it's a continuous trade whose value 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 to reduce 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 going all-in on random EURUSD trades and going all-in in 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
I cover all these points later on this page.
Risk Management and Trading Emotions are good friends - they like each other's company!
Trading emotions and psychology are often directly connected to risk and money management.
Emotions can be intense when trading. They can lead a trader to deviate 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 = less intense 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 emotion-driven decision 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, a significant profit. The trader fears a price reversal and losing the significant floating profit, so he deviates from the strategy and closes the position too early. This leads to short-term relief but long-term frustration, as the strategy will underperform.
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A trader is frustrated with her performance. She becomes impatient and opens 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. Being uncompromising with your risk management rules should let you keep trading, even after losing days, weeks, or months. It helps keep losses small and avoid blowing up their trading accounts.
3. Increase your chance of success. Less emotional traders who preserve 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 deep understanding and an 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 lets you limit your risk per trade and avoid the pitfall of holding 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 trade emotionally or blow up their 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
Potential rewards should be greater 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. Winners are always bigger than losers
Even though risk-to-reward doesn't directly reduce risk, it helps manage your account balance and adds more logic to your actions.
Risk-to-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.
Your entire account balance is always at risk, especially if you are trading without strict position sizing and use high leverage. Only fund what you are willing to lose, because you could 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 available trading funds, you effectively reduce 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 helps protect your funds and gives you 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.
Access to high leverage doesn't inherently make trading riskier. However, using high leverage can make trading more dangerous if traders choose 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. Lower leverage automatically reduces the risk a trader can take.
Leverage of 1:30-1:100 should be more than adequate when trading Forex. IC Markets allows you choose 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 cause trades to stop 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 open positions that are exposed to the same currency increases risk. Avoid being overly exposed to a single currency at any given time.
Being long or short multiple currency pairs that are positively correlated can lead to multiple 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 multiple trades are potentially correlated, or reduce position sizing when opening multiple positions in 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.