The Importance of Risk Management in Forex Trading

Forex is an exciting and dynamic speculation tool, but it comes with risks similar to other markets, and deserving of the same precautions that should apply in any speculative market. Risk can be mitigated using the proper tools, money management and sound trading practices. Be aware of the risks and ensure you are willing to take those risks, before you act.

Do not take these warnings lightly. Education includes knowing when to act and, perhaps more importantly, when not to act. Also true is that an advantage in one situation could be a disadvantage in another. Acting boldly and seizing an opportunity may be wrong if caution and temperance are required. Before you act, ask yourself if you are honestly making the right move. The old rule of investing in the stock market applies equally in forex trading: Do not invest any amount unless you are fully prepared to lose that amount.

All Traders Lose Sometimes Due to Leverage

Recognize that all traders sometimes find themselves on the wrong side of a trade. Different traders might handle the situation in different ways, but they all must maintain discipline and strive to overcome emotion in their trades. After all, nobody wants to exit a trade at a loss, and most traders would emotionally prefer to stay in a losing trade, hoping that the market will turn around and prove that they were right, after all. However, a trader must strive to detach themselves from emotional ownership of their trades — both winning and losing and make objective decisions based on a realistic and honest appraisal of the present situation.

Money Management Is Key

Investing money wisely means being aware of what you are doing with any particular monetary unit. While you may be able to afford to lose money in the forex market, prudent trading means not putting it all at risk at once. Eventually everyone loses some money. Use only a small percentage of your available funds with each trade. While this limits the amount of profit, it also limits the downside in case of a loss.

Adopt and Maintain a Neutral Trading Style

The excitement of real time trading and the thrill of seeing an investment rise, or fall, can sway anyone. That’s why finding an appropriate trading style, and staying with it, is crucial for risk management. Staying detached or objective about the investment while keeping emotions in check allows for the clear thinking required to make appropriate trading decisions. Keeping a neutral outlook as trading occurs allows the larger picture to be evident, and ensures that the planned trading style is fulfilled without being biased by temporary changes.

Use Stop and Limit Orders

Stop and limit orders can be important risk management tools. Be sure to learn how they work, and how they can fit into you trading methods and risk management strategy.

Stop orders are usually used to limit losses in a trade or to lock in profits in the case that the currency pair price moves against the position of the trader. One way a stop order can be used is to place the stop price slightly below the entry price on a buy or long trade or slightly above the entry price on a sell or short trade. If the currency price changes unfavorably, the stop price will be hit and the trading platform will automatically close the trade. The trade will be closed at a loss, but not as much of a loss as would occur if the trade remained open, and the currency continued to move against the trade.

A popular stop loss strategy is to use trailing stops. Throughout a profitable trade, the trade moves the stop price as to lock in profits. In a buy, or long currency trade, the trader will move the stop higher as the currency pair price increases. In that way, when the currency market trend reverses, the trailing stop price will be hit, and the trade will be automatically executed, at a profit. Some trading platforms even automate the movement of trailing stops.

Although stops are an important tool in risk management, something of which to be aware is that the use of stops can lead to losses, particularly if the stop price is set too close. If the stop price is set too close to the entry price, a small dip in price can trigger the stop trade, even though the trade might be proven correct a few minutes later.

Limit Use of Leverage

As noted, leverage can be a useful tool, but know when to use it. Remember that using leverage of any amount means borrowing money. Leverage of 100:1 means a deposit of $1,000.00 can be used for up to $100,000.00 of trading. In this case, an unfavorable change of just 1% of the value of the currency is enough to completely deplete your margin account. To restate this perhaps more powerfully, with leverage of 100:1, a 1% change can result in a 100% loss. The lesson to remember is that leverage allows for dramatic gains, and potentially devastating losses. Be careful with your leverage.