Forex Risk Management – Forex Academy

Risk, something that you are either afraid of or something that you love, whichever one is you, controlling it is vital if you want to become a successful trader. When you first started you probably created something along the lines of a risk management plan, this will tell you what you should be trading with each trade, what your stop losses should be and all sorts of other important information, its purpose is to protect your account from losses so that you are able to survive a number of losses before losing your account.

The thing is though, a lot of people make one, but make a small one, one with not a lot of information in it, or they simply decide to just ignore the rules that they have worked out. Whichever way they do it, they are avoiding the controlling of their risk, and eventually, this will lead to disaster and the possibility of a completely blown account. When the risk involved starts to rise, we often end up doing things that we would;t ordinarily do, such as closing out trades early, closing out for losses, or simply coding everything through a panic. We will promise to learn from these mistakes, but as soon as we get into a similar situation, we will normally do the exact same thing, not learning from the past, simply because we are not using proper risk management.

The issues start to arise when the risks that you are taking are larger than your risk tolerance levels allow, some of us love the risk others hate it. A lot of traders, especially newer ones will spend all of their time looking and working out when to enter a trade, but they often don’t put a lot of thought into when they will get out, this is where risk management needs to come into play. It is all about working out when you need to get out of your trades, both in winning and losing positions, but of course, being able to limit your losses when your trades are going the wrong way is vital and one of the most important aspects of your trading. So while it is important to know when to get into trades, you need to also work out when you will get out, prior to actually getting into it.

You need to work out where your risk tolerance lies and then adjust your risk management to suit it, the last thing that you want is to be a nervous wreck every time that you put on a trade. It is the same the other way around too though, you want to have some form of caring with each trade, if you do not care about the risk then you will be making silly trades, making trades you probably shouldn’t a risking far too much with each trade, simply because you do not care about the consequences. So it is a bit of a balancing act, but we are now going to look at some of the things that you can do to help manage your risk.

Trade Sizes

Trading with a large trade size can mean that you can make a lot more profit on each trade, on the flip side, you can also make much larger losses, the volatility will go through the roof the larger the trade size you use. So while it can be exciting, especially for those with good risk tolerance, it can be a nightmare for those without, and potentially a disaster for your account. You need to bring your trade sizes more in line with your account balance. Many people decide to risk between 1% or 2% per trade, this gives you a lot of leeway for losses, a loss will only cause you to lose up to 2% of your account and so when you do lose, it is limited and sustainable. If you aren’t able to work out what your trade size should be then it would be best to start small and then work your way up until you reach the appropriate level.

Holding Trades

For many there is only short-term trading, something only becomes long-term trading when one of the short-term trades stays in the red, people just don’t want to close out trades when they are in the red and this is an extremely risky move to make. The longer that you hold onto a trade, especially when it is in the red, the more volatility it is exposed to, this volatility is what is dangerous to your trade and can continue to take it in the wrong direction. You need to be able to limit how long to hold onto trades. If your average trade length is 10 hours, then why would you suddenly hold on to one for 7 days? You shouldn’t and so you need to set a limit to your trade times, try to keep them relatively the same, there is no harm going a little over now and then, but do not suddenly start holding on to them for 10 times your normal length.

Stop Losses

Stop losses! Use them! That is about all we need to say. Stop losses can save an account, they are that important, if you aren’t quite sure what they are yet, they are a limit that you put on each trade, a certain level, when the markets reach that level the trade will automatically close. If you are trading a strategy that requires longer-term trades then you won’t want to be in the position where you need to sit in front of the computer for the next 12+ hours, so instead, in order to protect your account you will put on a stop loss to ensure that you only risk the amount that you are willing to risk. This is a fantastic way of protecting your account and something that you should certainly use.

To go along with the stop losses and take profits, these work in exactly the same way but instead of closing out losing trades, they will close out trades that are positive. This is a way of ensuring that you take the expected or wanted profits, often when a trade goes positive it will eventually return back to a negative figure, this is a way of ensuring that you take the profits even when you are not at your trading terminal.

Risk to Reward Ratio

Your risk to reward ratio details how much you should be winning and how much you should be losing on each trade, this also dictates where you put your stop loss and take profit levels that we mentioned up above. It is important that you understand how this works, it can make or break a strategy as having a bad risk to reward ratio can make your strategy unprofitable. If you are trading at a 1:1 ratio then it can be quite hard to be profitable, you will need more winning trades than losing to be profitable, something far easier said than done. Instead aim to have a reward ratio of at least 2:1, some go as high as 10:1, which would mean that you would only need one trade to be profitable out of every 10 in order to be in profit. Work out what works well for your own risk tolerance as well as your strategy.

Those are a few of the things that you can do to help control your risk when trading, there are of course far more things that you can do, these are just some of the basics. What is important for you to take away is that you need to manage your risk, without doing so you will end up losing a lot more than you expected, so get on top of it and you will be in a good position for being a profitable trader.

Risk management in forex is of extreme importance and traders around the world have often struggled with overexposing themselves in one currency. We will address this issue using our trading system as a practical example. Exceeding the 2% risk limit (according to our risk management using our algorithm structure from previous articles) without having any awareness of how these oversights occur is almost every beginner trader’s mistake. These scenarios are frequently driven by a news event or some other occurrence that affects the specific currency they are trading, which consequently leads to an enormous loss. These losses can at times be so grave that they completely extinguish a trader’s account or erase several-month-long work despite traders’ initial efforts to maintain the risk at 2%. Interestingly enough, it typically happens that most trader’s individual trades are properly set at 2% when the exposure to only one of those currencies turns out to be increasingly higher. Today we are going to assess risk from several real-life situations and discuss them in order to gain some insight into how to manage risk better.

Imagine a situation where a trader who is already going long on EUR/USD gets a new signal somewhere along the line to enter a new trade and go short on EUR/GBP. The trader does not ask any questions and enters the trade as the system suggested, setting the risk at 2%. Naturally, if the system has been properly tested, there is a high chance of winning both trades, which is important for beginners as they often shy away from these situations. Although it may seem like too much risk, these circumstances can prove to be quite fruitful. Despite the fact that these occurrences happen often and that the outcome is generally positive, the trader from the story made a single mistake thinking that the risk on the EUR equals zero. The risk, in fact, is 2% long and 2% short at the same time, which further entails that the trader will not take any other EUR-based trades unless at least a portion of the existing trades is closed. What traders frequently fail to grasp is that the 2% short and long, despite the opposition in direction, cannot cancel one another or equal 0%.

Another situation involves a trader who received two long signals for EUR/CHF and EUR/USD and decided to enter both trades at the same time. In order to manage risk in these ongoing trades, the trader would need to take 1% from each trade to have a 2% risk on the EUR. If the individual for some reason decided to exit either of the two trades, the risk would come down to 1%. In this case, the traders could enter another trade or a continuation trade of the one that had just been closed. The trouble is that many traders assume that they somehow have their whole 2% here, which then leads to increased risk. The goal here is to fit into that 1% that we have left after the second trade was closed.

Should a trader receive a EUR/USD long signal but then reconsider his/her options because another EUR-based pair is likely to get there in one day, they can take a 1% risk on the first currency pair and wait for the 24h to pass to see what will happen. The other trade may or may not get to the place we hoped or expected it to reach, which can be quite unsettling but does not involve any increased risk or missed-out opportunity since the previous requirement was met. The equity is settled with the EUR, so the trader can, if he/she wishes, enter a new trade later on when an opportunity presents itself. Even if you decide to enter a 2% EUR trade in the beginning without waiting for the situation with the other pair to fully develop, there is no mistake made. The choice falls on the traders alone and no damage is done until the risk limits are properly sit – 1% on one of the two trades or 2% on a single trade.

Sometimes it happens that the market is quite active and that prices are moving, so you can get several signals on a single currency at a time. What you should do here is divide the 2% by the number of trades you wish to enter. Therefore, if you received four signals for four EUR trades, make sure that each of the four trades has a 0.5% risk. While this may seem like a lot, it actually can prove to be both useful and lucrative as long as the risk is managed well. If you assumed that the EUR is going to do well and your assumptions prove to be correct, you will take wins in all EUR-based trades you entered. However, if your assumptions somehow turn out the other way, your trades are secured because the proper risk management can function as a form of a hedge.

While this is an excellent strategy and a secure way of protecting oneself, this does not imply that any trader should go on a spree looking for several trades involving one currency as this often fails to bring the results we are hoping to get. The system you have worked to build should be enough as a source of signals, so there is no need to go beyond that. Moreover, it is also extremely important for traders to trust their algorithms when we do get several signals for one currency at the same time and not miss opportunities out of fear.

Traders can sometimes be misguided by the sudden success they experience in some of these situations when they win instead of losing despite not having set the risk properly. Such outcomes can be particularly dangerous for the understanding of how risk management truly works. Once the winning part ensues, traders can get so excited that their thinking processes get affected negatively and no logical conclusion can be drawn as a result. In order to overcome this challenge and improve your overall trading, especially if you are at the beginning of your forex career, you should devote time to learn about money management and trading psychology, which will prove to outdo all other forex-related topics by far.

The more advanced traders who have already started backtesting their systems may be experiencing some difficulty due to the inability to apply today’s advice during these processes. The problem with dividing risk while backtesting is that it would make the whole assessment that much longer, so the suggestion here is to test the system on different currency pairs one by one. Overexposure prevention is important but, for the backtesting part, it would dimply overcomplicate everything, However, during the forward testing, whose purpose is to gain more clarity and see the things which may be fixed, you can expect to see some differences. This second part of testing should also serve to prepare you emotionally for trading real money and traders should, thus, be particularly vigilant throughout the process. Any of the parts that you do not focus on entirely or fail to address with a sufficient amount of attention during the demo phase will inevitably haunt you down later on and probably in a much more serious situation affecting your or other people’s finances.

As we described above, the dangers of accidental success are real, which calls for increased attention to testing processes where one can discern what works well and what can potentially endanger his/her entire forex career. If you suddenly go into the negative having taken a few losses in a row after an incredible 15% win is quite indicative of a malfunctioning system. The challenge here is not to interpret the word system as tools, numbers, and indicators alone because, as we said before, money management and trading psychology are superior to any technical aspect of trading in the spot forex market. Even if you have already lost a lot and feel doubtful about your abilities and knowledge on trading, what you can and should do is go back to the basics – start a demo account and devote the proper amount of attention testing requires.

Therefore, to sum it all up, if you are intent on trading a single currency through several trades, make sure that your 2% risk is divided accordingly, based on the number of trades you enter. We can see from this how trading requires precision both in terms of settings and emotions. Traders may know everything there is to know about entering a few trades involving the same currency at the same time, but the excitement and the enthusiasm may still blur their vision and prevent them from interpreting their results in an objective manner. The testing should help traders get accustomed to their systems, wins, and losses, but the topic of risk management cannot unfortunately be applied in this format to backtesting due to its complexity. The psychological side of trading can become increasingly heavy on the trader if they fail to recognize which role their emotions play in risk management, causing traders to either take too little or too much risk. While forex is a complex net connecting various fields of our existence, articles such as this one can serve to guide individuals on their way of bettering themselves, their prospects of making money, and thus their living conditions as well.