What is Forex Risk Management? Learn the Basics

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Effective forex risk management allows currency traders to minimize losses that occur as a result of exchange rate fluctuations. Therefore, having a proper forex risk management plan can make for a safer, more controlled and less stressful forex trading. In this piece, we cover the fundamentals of fx risk management and how best to incorporate them into your process.

What is forex risk management?

Forex risk management includes individual actions that allow traders to protect against the downside of trading. More risk means a higher chance of sizable returns – but also a greater chance of significant losses. Therefore, being able to manage the levels of risk to minimize loss, while maximizing gains, is a key skill for any trader to have.

How does a business owner do this? Risk management can include establishing the correct position size, setting stop losses, and controlling emotions entering and exiting positions. Well executed, these measures can prove to be the difference between a profitable business and losing it all.

Top 5 Fundamentals of Forex Risk Management

1. Appetite for Risk

Working out your appetite for risk is central to proper forex risk management. Traders should ask: How much am I willing to lose in a single trade? This is especially important for the most volatile currency pairs such as certain emerging market currencies . Also, liquidity in forex trading is a factor that affects risk management, as less liquid currency pairs can mean that it is more difficult to enter and exit positions at the price you want.

If you don’t know how much you’re comfortable losing, your position size can end up too high, resulting in losses that can affect your ability to take the next trade – or worse.

Let’s say 50% of your trades are winners. In the long run, mathematically you can expect to have runs of multiple losing trades in a row. Over a trading career of 10,000 trades, the odds suggest you will face 13 consecutive losses at some point. This underscores the importance of knowing your appetite for risk, because you need to be prepared, with enough money in your account, for when bad runs hit.

So how much should you risk? A good rule of thumb is to only risk between 1 and 3% of your account balance per trade. So, for example, if you have a $100,000 account, your risk amount would be $1,000-$3,000.

2. Position Size

Choosing the right one position size , or the number of lots you take in a trade is important because the right size will both protect your account and maximize opportunities. To choose your position size, you need to work out your stop placement, determine your risk percentage, and estimate your pip cost and lot size. For more on how to do these things, click the link above.

3. Stop Losses

Using stop loss orders – which are set to close a trade when a specific price is reached – is another key concept to understand for effective risk management in forex trading. Knowing the point in advance at which you want to exit a position means you can prevent potentially serious losses. But where is this point? Generally, it’s whatever point your initial business idea is canceled. For more details on this concept, click on the ‘Using stop loss orders’ link above.

How to use a stop loss order to manage trading risk

Traders should use stops as well as limits to enforce a risk/reward ratio of 1:1 or higher. For 1:1, this means you risk $1 to potentially make $1. Place a stop and limit for each trade, making sure the limit is at least as far away from the current market price as your stop.

The table shows how the results of different risk-rewards can change a strategy:

Risk Reward 1-1 1-2
Whole Businesses 10 10
Total Wins (40%) 4 4
Profit Objective 100 pipes 200 pipes
Stop Loss 100 pipes 100 pipes
Pips Won 400 pipes 800 pipes
Pips Lost 600 pipes 400 pipes
Net Earnings (-200 pips) 200 pipes

As can be seen in the table, if the trader only sought one dollar in reward for each dollar risked, the strategy would have lost 200 pips. But by adjusting this to a 1-to-2 risk-reward ratio, the trader tilts the odds back in his favor (even if only right 40% of the time). For a complete breakdown of this concept, read more risk reward ratios for forex .

4. Leverage

Leverage in forex allows traders to gain more exposure than their trading account might otherwise allow, which means a higher potential to profit, but also a higher risk. Leverage should, therefore, be managed carefully.

Investigating how traders fared based on the amount of trading capital used, DailyFX Chief Strategist Jeremy Wagner found that traders with smaller balances in their accounts generally had much higher leverage than traders with larger balances. However, the traders using less leverage saw much better results than the smaller balanced traders using levels above 20-to-1. Larger-balanced traders (using an average leverage of 5-to-1) were profitable more than 80% more often than smaller-balanced traders (using an average leverage of 26-to-1).

Based on this information, at least when starting out, it is advisable that traders be very careful in using leverage and pay attention to the risks it presents.

5. Control Your Emotions

It’s important to be able to manage the emotions of business when you risk your money in any financial market. Letting excitement, greed, fear or boredom influence your decisions can expose you to excessive risk. To help you remove your emotions from the equation and trade objectively, keeping a forex trading journal or log can help you refine your strategies based on previous data – and not on your feelings.

Forex risk management: A case study

DailyFX analyst Nick Cawley explains a business he did EUR/USD showing the processes that go into sound forex risk management.

DailyFX analyst Nick Cawley

“I opened a long position on EUR/USD at 1.1100 with 1:3 risk/reward and a position of £5 per. pip , representing only 3% of my account balance. This was an attractive trade on the charts and meant I would profit £300 if the target was met.

To protect against losses I set a stop loss at 20 pips away, because below this mark I would not feel comfortable with the trade. I chose the leverage of 1:1. Doing all these things and recording the trade in a journal meant I was able to minimize emotions and manage risk in the most efficient way possible.”

Forex risk management: Best takeaways

In summary, to practice sound forex risk management, traders should:

  • Work out their attitude to risk, thinking about risk/reward ratio, position size and percentage of account balance for each trade.
  • Place stop losses to protect against the market against their position
  • Beware of leverage and overuse
  • Keep a handle on emotions
  • Use a journal to make decisions based on existing data rather than personal feelings.

Further reading on forex trading

For more information on getting started in forex trading, download our New To Forex trading guide , the perfect introduction to the world’s largest financial market. Traders of all levels can also learn what our DailyFX experts trade in our Analyst’s Choices section



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