Managing risk plays an important role in successful trading, whether you trade stocks, bonds, commodities or currencies. Risk management for forex traders remains an important part of a prudent trading plan due to the volatility inherent in the currency market.
While such volatility may present many trading opportunities to profit from, it also means that traders are exposed to a substantial amount of risk when carrying open forex positions. In this article, we show you how to gauge the risks in the forex market and use the best methods available for forex risk management.
Common Risks for Forex Traders
The main reason traders lose money is not because of inexperience or lack of market knowledge but from poor money and risk management strategies, regardless of the particular market traded. Knowing how to manage risk appropriately remains one of the cornerstones of successful trading and can help you build wealth instead of squandering it. The most common forex trading risks to consider consist of:
- Exchange rate risk: This risk involves having exposure to unforeseen changes in exchange rates.
- Leverage risk: Leverage in the forex market is a two-edged sword often used by retail forex traders to magnify profits and losses.
- Liquidity risk: Although the forex market is among the world’s most liquid, certain events may trigger notable episodes of illiquidity.
- Interest rate risk: The value of fiat currencies relative to one another depends in part on the respective benchmark interest rates set by their issuing central banks that add value for foreigners holding a particular currency.
Risk Management Strategies for Forex Traders
Trading forex without a sound money and risk management strategy is a recipe for disaster in the form of the ultimate loss of your trading account money. The following list includes strategies that can help you manage various forms of risk you might encounter when trading currencies.
Learn About the Forex Market
Having a working understanding of the fundamentals of the forex market and what drives exchange rate movements is an invaluable resource for currency traders. Also, having a strong grasp of technical analysis can provide objective trading signals that give forex traders a useful basis upon which to make quick trading decisions.
At a minimum, forex traders should aim to remain well-informed about the overall state of each country that issues the currencies they trade. This should include the country’s central bank’s monetary policy stance, its economic health and any relevant geopolitical issues. Having this information already stored in your memory bank allows you to make quicker and better-informed analyses of the forex market, which in turn tends to result in more attractive trade entry points and more profitable trades.
In practice, most successful traders use a combination of fundamental and technical analysis. The technicals let them better assess the levels of supply and demand existing in the market, while the fundamentals indicate the market’s overall direction based on economic releases and other news that might affect the value of one currency relative to another.
Understand Leverage
Although leverage is definitely a two-edged sword, due to the rather moderate level of volatility typically observed in the forex market, using a certain amount of leverage probably makes sense if you plan on making money as a currency trader.
You will want to select a prudent leverage ratio that suits your risk tolerance. Also, assessing your pain threshold given the leverage ratio you intend to use before even taking a trade is an important part of money and risk management.
If you’re a retail trader based in the U.S., you are only allowed to use a maximum leverage ratio of 50:1, while EU and U.K. residents can only leverage forex positions up to a ratio of 30:1. If you live outside of these jurisdictions, you may be able to access much higher leverage of up to 1,000:1 via some offshore online forex brokers.
Use a Trading Plan
The main difference between gambling and trading in the forex market consists in the strategic use of research and analysis by a trader to establish potentially profitable trading positions with the highest chance of success. In contrast, a gambler will typically operate based on guesses or hunches at best.
The way that profitable forex traders typically find potentially profitable opportunities in the currency market depends on their analysis, as well as on their prudent implementation of sound money management and risk management methods. Savvy traders generally also develop and implement a promising trading plan and then stick to it in a disciplined manner to optimize their chances of success.
Most trading plans involve performing technical analysis to identify the existence of trends or trading ranges in the market at a minimum. By using exchange rate graphs and a selection of complimentary technical indicators, sensible traders can develop a trading plan that sets up objective buy and sell signals for them to follow.
Other trading plans might involve trading on major economic data and news releases. If you find performing market analysis and developing a trading plan difficult, but you still want to profit by trading in the forex market, you can look into social trading. This allows you to copy the trades of successful traders in your own account.
Choose a Sensible Risk-Reward Ratio
Some gambling strategy elements can be extremely useful to traders. Assessing the odds of success and determining risk-reward ratios for a trade can play an important role in forex risk management. The risk-reward ratio represents the amount of risk you intend to take for a given amount of profit — or reward — you expect to make on a given forex position.
As an example, if you are willing to risk $100 for the chance to make $100, then your risk-reward ratio is 1:1. Alternatively, if you risk $100 to make $300, then your risk-reward ratio is 1:3.
Knowing your risk-reward ratio before you initiate a trade gives you an indication of where to exit the trade. It also lets you place a stop-loss order in the market right away to avoid risking more than you’re comfortable with in any one position.
Use Limit and Stop Orders
Limit orders let you tell your broker to establish a market position or take profits on an existing position for you at your desired exchange rate level that is better than the current market rate. These orders let you wait for the market to move in a way that favors you before entering or exiting a position.
For example, if you want to buy the EUR/USD currency pair at an exchange rate of 1.1500, but the market is currently trading at 1.1600, then you can leave a limit order with your broker to buy when the exchange rate reaches 1.1500. If the market ever trades at that level while your order remains active, your order would be filled.
In contrast, stop orders are placed at a worse level than the current market level. Stop orders can be used to keep profits from eroding excessively or to keep losses manageable on a losing position, in which case they are called stop-loss orders. Once a stop order is triggered by the market trading at the specified level, it then becomes a market order to execute the specified transaction at the best possible exchange rate.
Stop orders can also be entered away from the prevailing market. For example, a buy-stop order can be entered above the market to buy at an exchange rate above a technical resistance level once it has been breached. A sell-stop can be entered below the current market.
Many people with existing positions use stop-loss orders to limit their risk on both long and short positions. Stop-loss orders are an important risk management tool in forex trading and are widely used by retail and professional traders alike.
Keep a Cool Head
While logic may not be a chief feature of the forex or any other financial market, remember the old adage, “the market can stay irrational longer than you can remain solvent.” Markets can be extremely volatile, and losing money can challenge anyone’s peace of mind when a position goes substantially against them.
Having a sensible trading plan incorporating sound money and risk management principles will help you keep a cool head in a fast market. This is one of the key elements that separates profitable traders from the roughly 90% of other traders who lose money trading in the forex market.
Read the News Daily
Anyone who has traded in the forex market for a substantial length of time can attest to the importance of major news events and the notable effect that economic data releases can have on relevant exchange rates.
Most successful traders keep a watchful eye on the economic calendar and business news feeds because exchange rates can be highly and sharply influenced by such releases. Also, natural disasters, elections, social unrest and even commodity price changes can notably influence affected exchange rates.
Use a Demo Account First
Before you commit any funds to a forex trading account, remember to open a demo account to get an idea of how the forex market trades. Fortunately, most online forex brokers offer free access to a demo account these days.
Demo accounts let you trade in the forex market in real-time with virtual money so you can avoid putting any actual funds at risk. This allows you to gauge the broker’s trading platform, practice trading and test your trading plan.
If the broker and your trading plan look good after some practice, you can then open a live account and deposit some risk capital to start trading properly. Trading in a demo account can be an invaluable experience for traders with no experience. It can also be useful for seasoned traders when evaluating a trading strategy or plan.
Is Forex Trading for You?
Forex trading involves taking strategic exposures to currency pair exchange rate movements. Since trading currencies has more in common with gambling than investing, risk management can make a big difference to your ultimate success. If forex trading sounds like something you would like to learn more about, then come back to Benzinga often for more expert information on the subject.
Frequently Asked Questions
How is risk management calculated in forex?
In various ways depending on what type of risk you are looking to manage. One common risk management method involves computing a certain amount of monetary risk you are willing to take per trade, which is often calculated as a small percentage of your available trading capital. Using a 2% risk rule and a $5,000 account size as an example, you would set your maximum loss per trade at $100. If you are trading mini lots in EUR/USD, then 1 pip will be worth around $1, so you can risk up to about 100 pips. You might therefore set your stop-loss level 100 pips away from your trade entry point as part of your risk management strategy.
How can you reduce risk in forex?
You can reduce risk as a forex trader by knowing what moves the market and keeping an eye on those factors, performing fundamental and technical analysis, having stop orders in the market when you have open positions, and having a trading plan that incorporates sound money and risk management principles.
Is risk management in forex important?
Since forex trading is risky to begin with, forex risk management is an important part of success in the market.
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About Jay and Julie Hawk
Jay and Julie Hawk are the married co-founders of TheFXperts, a provider of financial writing services particularly renowned for its coverage of forex-related topics. With over 40 years of collective trading expertise and more than 15 years of collaborative writing experience, the Hawks specialize in crafting insightful financial content on trading strategies, market analysis and online trading for a broad audience. While their prolific writing career includes seven books and contributions to numerous financial websites and newswires, much of their recent work was published at Benzinga.