Chapter 16. Forex Risk Management Strategies

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It’s pretty common for new Forex traders to think making money through online Forex trading is fast and easy.

However, it’s a process that takes time, dedication, commitment, and patience, if you want to be successful and profitable in the Forex markets in the long run.

You can’t just open a position in your trading platform without taking into account the trading conditions set by your Forex broker, the market, leverage, liquidity and counterparty risks, that affect your capital. A legendary Forex trader once said:

Don’t focus on making money; focus on protecting what you have.Paul Tudor Jones

You also need to apply tools and techniques to manage your money and risks – if you don’t do those things, you wouldn’t be trading – you’d be gambling.

#1 Only trade money you don’t need

It might sound obvious, but the first rule in Forex trading, or any other kind of trading for that matter, is to only risk the money you can afford to lose. Many traders, especially beginners, skip this rule because they assume that it “won’t happen to them”.

If trading were like gambling at a casino, you wouldn’t take all the money you have to the casino to bet on black, right? Well, it’s the same with trading – don’t take unnecessary risks by using the money you need to live on.

Why?

Because it’s possible to lose all your trading capital, and secondly, because trading with funds you live on will add extra pressure and emotional stress to your trading, compromising your decision-making abilities and increasing the chances of making mistakes.

The Foreign Exchange markets are volatile, so it’s better to trade “conservative amounts” from your disposable income. If you can’t afford to lose the money you’re trading, then, unfortunately, trading is not for you.

#2 Always use stop-loss and limit orders

Orders are instructions to your broker to place a trade when the price in the underlying market hits a certain level. By way of a reminder, here is how stop and limit orders work:

Stop-loss orders are placed on an open position to get you out of a trade if the market moves against you, it ‘stops your loss’.
 
There are three reasons why you should set stop-losses and limit orders on every trade:

  • It is just common sense to protect your downside. 
  • Your mindset is better, you can leave your trading screen knowing there is some degree of protection in place.
  • The process helps you sense-check the trade against your trading plan.
 

#3 Think about your risk tolerance

Before you start trading, you need to determine your risk tolerance, depending on:

  • Your age
  • Your knowledge of FX trading
  • Your experience
  • How much you’re willing to lose, and
  • Your investment goals

Having a feel for your risk tolerance is not just about helping you sleep better at night, or stress less about currency fluctuations. It’s about knowing you are in control of the situation because you’re trading the right amount of money vis-à-vis your personal financial situation in relation to your financial objectives.

Keep your trading within your risk tolerance and you increase the likelihood of trading success.

Read: Is the Forex Market Right For you? Find Out Here

#4 Set your risk/reward ratio to a minimum of 1:2

Knowing about the risk/reward ratio (RRR) will definitely improve your chances of becoming profitable in the long run, and setting stop-loss and limit orders that protect your capital.

A RRR measures and compares the distance between your entry point and your stop-loss and take-profit orders. 

 We’ll get onto trading styles in the next chapter but scalpers and day traders should aim to have a minimum RRR of 1:2, longer-term swing and position traders should aim for a wider minimum of 1:3

For Example
If the distance between your entry-level and your stop-loss order level is 50 pips, and the distance between your entry point and your take-profit limit order level is 150 pips, then you would be using a RRR of 1:3, because you’re risking 50 pips to potentially make 150 pips (150/50 = 3).

The risk/reward ratio is a necessary tool to set your stop-loss and take-profit orders depending on your risk tolerance, and every wise trader should control the downside risk.

Read: What are pips?

#5 Control your risk per trade

You also need to consider your risk per trade as a percentage of your trading capital and set it at a conservative level, this is especially important when you’re new to trading and are likely to make more mistakes than someone with experience.

You should only risk a small portion of your trading capital per trade: a good starting point would be to not risk more than 1% of your available capital per trade. If you’re applying sound RRR then that means risking 1% to potentially return 3%. 

Here is the impact of three different per trade risk levels – 1%, 2% and 10% – on an account balance of 100,000 over a 30 trade losing streak. The trader risking 10% per trade has lost 95.3% of their account balance, the trader risking 2% is down 44.3% and the 1% trader is down 25.2%.

We’re showing you this to make the point that the more a trader risks per trade then the harder it is to rebuild capital after a series of losing trades, although it might not be 30 in a row, which is very unlikely, losing streaks do happen – to every trader at some point – and you don’t want them wiping out your capital so you can’t rebuild. 

#6 Keep your risk consistent

Most beginners will increase the size of their positions as soon as they’re making profits, which is one of the best ways to get your account wiped out. Keep your risk consistent.

Do not become over-confident and less risk-averse
Just because you’ve made a few winning trades doesn’t mean the next one is going to be profitable.

Do not become over-confident and less risk-averse, as that will lead to you changing your money and risk management rules without solid reasons.

When you worked on your trading plan, you had to set up rules to decide about an effective size for your positions. This is just one step in establishing a successful trading method, now you need to stick to and follow your trading plan!

Read: 9 of the Best Forex Trading Books for Beginners

#7 Understand and control leverage

The three margin products we’ve introduced so far in the guide – spot Forex, CFDs and spread bets – are all leveraged products.

Leverage means that you can trade more money than your initial deposit, thanks to margin trading. Your broker will only ask you to put aside a small portion of the total value of the position you want to open as collateral.

When using leverage, your profits can be magnified quickly, but remember the same applies to your losses in equal measure. This is why you need to understand how leverage and margin trading work, as well as how they impact your overall performance and trading.

Forex traders are often tempted to use high leverage to make significant profits, but if you’re over-leveraged one quick change in the market, or a simple mistake, could end up with an outsized hit.

Revealed: The Dangers of Forex Trading

To note
In August 2018, the European Securities and Markets Authority (ESMA) imposed limitations on the leverage offered by brokers. These leverage limits on the opening positions by retail traders vary depending on the underlying:

  • 30:1 for major currency pairs, and
  • 20:1 for non-major currency pairs.

ESMA did this for a reason: retail traders, especially new ones, are normally bad at managing leverage and end up losing money because of it.

 If there was only one titbit you took from the whole guide it would be to really learn about how leverage risk works and how you need to actively manage it to be a good trader. 

#8 Take currency correlations into consideration

Because currencies are priced in pairs, it’s important to understand that currencies are linked to each other, or correlated.

Knowing about Forex correlations will help you better control your Forex portfolio’s exposure by reducing the overall risks. Correlation represents a measure of how one asset’s price changes in relation to another.

If two assets are positively correlated, it means that they tend to move in the same direction, while if they are negatively correlated, they will evolve in opposite directions.

Live Forex pair correlations: heatmap

To use FX correlations to your advantage, you need to remember a few things:

Avoid opening several positions that cancel out each other
For instance, if you go long on the EUR/USD and the USD/CHF, you can expect both currency pairs to evolve in opposite directions, which is almost like having no trading position in your account.

Why?

Because the USD is used once as a base currency (USD/CHF), and once as the quote currency (EUR/USD), which means that if the USD strengthens against its major counterparts, then the EUR/USD will go down, while the USD/CHD will go up – the evolution of one exchange rate cancelling out the other one.

Avoid opening positions with the same base currency, or quote currency
For instance, if you go long on the EUR/USD, the AUD/USD, and the GBP/USD, you can expect these currency pairs to be positively correlated because they all have the same quote currency, the USD.

It means that when the USD strengthens/weakens, your portfolio will go up/down.

Be aware of commodity currencies
Commodity currencies represent currencies that move in accordance with commodity prices, because the countries they represent are heavily-dependant on the export of these commodities.

As a general rule, if the price of commodities strengthen, then the currencies of the commodity producers will go up – and vice-versa.

The main correlations to know about are the Canadian Dollar (CAD) and oil, the Australian Dollar (AUD) and gold/iron core, as well as the New-Zealand Dollar (NZD) and wool and dairy products.

To improve your Forex trading performance, you should understand your exposure: some currency pairs move together, while others evolve in opposite directions. The key is to diversify your portfolio to mitigate risks.

Bottom-line

These pointers are just the cornerstone to better manage your risk – as you research further, you’ll find other Forex trading tools and techniques for beginners you can use to improve your trading strategy.

Before using a live trading account, try to back-test your trading plan on a demo account, and improve your strategy if needed.

Review your trades on a regular basis with a trading journal that will help you understand what you did right, and what you can improve.

Learn from your mistakes, and accept responsibility for losses.

Regardless of the timeframes you use, whether you rely on technical analysis or fundamental analysis, always follow your trading plan. Control your emotions and be patient enough to wait for your trade setups to be confirmed before opening/closing a position.

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