Persons asking this question are tackling the essence of successful forex trading. One of the essential starting points is the mechanism to cut your losses before you try to get more winner trades. You will find that in team sports, defense plays a key role to win, it is a must before all else. Traders asking this question also show they understand measures need to be put in place and are wondering what are the ways to do that. Luckily, there are many ways to make trading more secure, traders, and generally, -economy schools call this risk management. How we make the risk of losing acceptable so, in the long run, we are consistently able to reap the rewards out of forex.
Other names for managing trades and the risks associated are Money Management since we are putting money into trades and also Portfolio Management, we are managing many different shapes of capital through holding different assets. However you like to call it, it is all how we limit our losses and maximize our wins. Therefore, some measures are more effective for certain trading strategies and completely inadequate for others.
Let’s put some simple wording here about the risk before we get into details. In forex trading, we have many factors that can ruin our trades. No strategy is immune to them so traders are careful, think about what could go wrong and also, what went wrong in the past. History is a good teacher, however, new things that ruin our trades come in more often nowadays, just because the economic activity goes wild in many directions. Whenever we need to solve a problem, traders measure the odds for and against, simple pros and cons of their decisions. If we are to put some capital at risk, to invest, we are looking at what could go wrong and if the probability of losing is justified for the rewards we might get. It is not only about the probabilities, it is also about the weight.
Losing 1% of your capital for a 5% gain seems like a good decision but if the outcome of winning is less than 15% then it is clear this is not good enough. However, if we have a 50-50 chance of winning, you are in for good long term performance if these opportunities repeat. Forex markets go up and down, can also go sideways for some short time but eventually, the price will move. Take a one-hour timeframe, for example, create your rule so you can get to a 50-50 chance of winning trades. This can be very simple, toss a coin every hour at the end of a candle. Set never to lose more than 1% of your capital with a Stop Loss order and set a Take Profit at 5x the Stop Loss. Close the trade after one hour unless your pending orders get triggered first. You will notice that after 100 trades the risk is limited whatever happens and over time you slowly get some profits.
Of course, you will also notice you can increase your winning odds and further protect from the risks, forex is not a random distribution, there is some certainty to it. Historic charts will present you with trends, patterns, and various meaningness we make out from what is seemingly random. At certain times, you will notice a trend emerges, and your random 50-50 decision does not make profits as it could have had it more trades in the trend direction. Time to make some adjustments. These adjustments slowly specialize to trend following strategies. If you notice the price bounces back from the channels you or some indicator creates, great, you are shaping your own reversal strategy. There are so many ways to trade forex, but every trader starts walking from risk management.
Now, adding on measures to your 50-50 decision-making results in more profits, even the odds are still 50-50. You could add more, say, a trailing stop. As the price moves in your direction, trailing limits the amount of weight you can lose. Consequently, if the trailing moves above your entry-level, you do not have any risks of losing, whatever happens, you can only win. You will notice this measure pushes your balance really well when you have a strong movement or in a trend. You may think closing your trade after every hour rule is not so beneficial anymore. Test it out, are you right? You probably are but make sure with a good testing sample on your demo account. Let’s get this money management even better. Diversify your positions with scaling out and moving Stop Loss to breakeven.
Diversifying is directly affecting the risk and in this aspect, we are diversifying the position size as the events unfold. Once your Take Profit is reached, close only 50% of the position and move your Stop Loss to breakeven if you are not using a trailing stop. Now not only you are protected from losing but you are open to grab a bonus from a trend that could last for many more hours or days. Compare your results with previous versions of your strategy after 100 trades for example (some traders go for 1000 trades sample). If it is better, your consistency increases as well as your gains. You may try to experiment with other risk management measures, such as scaling in, multiple take profit and exposure diversification, volatility-based pending orders placement, and so on, but do not overcomplicate things. Adding more rules does not always bring more profits.
The example above only tackle technical money management and only in one way with a few example tools. Other things are in play on the fundamental side. Investors manage their risk using economic indicators such as government measures, reports, country key figures, elected officials’ mindset and knowledge responsible for governing the country’s economy or certain branch, and many more. They mix in the risk weight and probability with their own calculus. Risk management is a special economic discipline after all. As a forex trader, you do not have to be a mathematician, just follow proven methods that are very easy to implement in your trading platform.
Risk has its categories and shapes, there are things we can control and those we cannot. Managing how big a trade is in relation to our total balance and market volatility is what we can control. We directly limit the risk with these measures. However, unforeseen events happen and there is nothing we can do. We will see losing streaks or sudden crashes however great our strategy is. This is an inherent risk we have to accept. There are other risks not directly tied to forex trading. We may have problems following our rules as we get emotional, we panic, we have a feeling, get angry, thrilled, we overtrade and overexpose.
Can we learn not to be emotional or is this our personality that we cannot shake out? We now raise the question of where is the border between our psychology and the risk we can manage? Is this defined as an operational risk? A lot of things can be thrown into the psychology basket, even risk management. Therefore, psychology and risk management are intertwined. If we explore and recognize the importance of risk management we have the right psychology, we do not seek out fun tools and strategies only to lose everything in a few trades. We do not seek to get rich quick ways and thrills of betting. Defense comes first, even though it is not popular. This is why many lose on forex, and why the title question reveals healthy interest, a sign you will probably belong to the successful minority.