Forex risk management can make the difference between your survival or sudden death with forex
trading. You can have the best trading system in the world and still
fail without proper risk management. Risk management is a combination
of multiple ideas to control your trading risk. It can be limiting your
trade lot size, hedging, trading only during certain hours or days, or knowing when to take losses.
Why is forex risk management important?
Risk management is one of the most key concepts to surviving as a forex
trader. It is an easy concept to grasp for traders, but more difficult
to actually apply. Brokers in the industry like to talk about the
benefits of using leverage
and keep the focus off of the drawbacks. This causes traders to come
to the trading platform with the mindset that they should be taking
large risk and aim for the big bucks. It seems all too easy for those
that have done it with a demo account, but once real money and emotions come in, things change. This is where true risk management is important.
Controlling losses
One form of risk management is controlling your losses. Know when to cut your losses on a trade. You can use a hard stop
or a mental stop. A hard stop is when you set your stop loss at a
certain level as you initiate your trade. A mental stop is when you set
a limit to how much pressure or drawdown
you will take for the trade. Figuring out where to set your stop loss
is a science all to itself, but the main thing is, it has to be in a way
that reasonably limits your risk on a trade and makes good sense to
you. Once your stop loss is set in your head, or on your trading
platform, stick with it. It is easy to fall into the trap of moving
your stop loss farther and farther out. If you do this, you are not
cutting your losses effectively and it will ruin you in the end.
Using correct lot sizes
Broker’s advertising would have you think that it’s feasible
to open an account with $300 and use 200:1 leverage to open mini lot
trades of $10,000 dollars and double your money in one trade. Nothing
could be further from the truth. There is no magic formula that will be
exact when it comes to figuring out your lot size, but in the
beginning, smaller is better. Each trader will have their own tolerance
level for risk. The best rule of thumb is to be as conservative as you
can. Not everyone has $5,000 to open an account with, but it is
important to understand the risk of using larger lots with a small
account balance. Keeping a smaller lot size will allow you to stay
flexible and manage your trades with logic rather than emotions.
Tracking overall exposure
While using reduced lot size is a good thing, it will not help you very
much if you open too many lots. It is also important to understand
correlations between currency pairs. For example if you go short on
EUR/USD and long on USD/CHF, you are exposed two times to the USD and in
the same direction. It equates to being long 2 lots of USD. If the
USD goes down, you have a double dose of pain. Keeping your overall
exposure limited will reduce your risk and keep you in the game for the
long haul.
The bottom line
Risk management is all about keeping your risk under control. The more
controlled your risk is, the more flexible you can be when you need to
be. Forex trading is about opportunity. Traders need to be able to act
when those opportunities arise. By limiting your risk, you insure that
you will be able to continue to trade when things do not go as planned
and you will always be ready. Using proper risk management can be the
difference between becoming a forex professional, or being a quick blip
on the chart.
