Forex risk management plan is a set of rules that help mitigate the impact of any risks that could threaten a trade. Risks are the potential threats that may cause losing money in forex trading. Managing risk is a key factor in successful trading.
“An investment business has certain risks, and your job as an investor is not to eliminate all risks but to manage and minimize them.”Naved Abdali
Risks of Forex Trading
There are different types of risks that can occur in forex trading. Some are related to the market nature, others may be an outcome of bad trading decisions or unexpected events.
- Market Risks: They are the risks when the market movements violate expectations. It is more related to the unexpected fluctuations in prices. For instance, buying the currency pair USD/JPY as you expect the dollar to rise, but the pair moves down due to constant change in market forces.
- Liquidity Risks: Liquidity reflects how actively an asset is being traded. There are some currency pairs, exotic pairs for example, that lack sufficient liquidity for trades to be executed instantly. This may cause traders to make smaller profits, and maybe even lose. There are also times when the market is less liquid. The overlap between the US and European trading sessions is the time of highest liquidity in the forex market, especially for major currencies.
- Monetary Policy Decisions: The monetary policy of a currency affects its performance against its rivals. Any unexpected change to this policy affects the currency directly and immediately, especially when it comes to interest rates that impact the currency’s value.
- Capital Risks: This risk does not involve market factors; it is the trader’s mistake. To elaborate, let’s say that you are planning to execute a long-term trade but your balance is relatively low. In this case, you trade will not survive any unexpected volatility and you may end up losing more than you planned. However, this can be managed by setting rules for your trading, based on your capital and risk tolerance.
- Leverage Risks: Some traders do not evaluate the risks of using high leverage levels, especially when they risk more than their capital in one trade. This is a common mistake that is usually overlooked.
10 Steps to Manage Forex Risks Effectively
Develop a Solid Trading Plan
Trading with a plan will make it easier to make good trading decisions by abiding by a set of predefined rules. A plan can teach you discipline and rationality especially in a volatile market. Remember that your personalized plan can be more effective, as it will be based on your own goals, capital, and approach. You can learn more about how to develop a forex trading plan while you are entering the market. Accordingly, it is always important to include forex risk management as a key factor in every trading strategy.
Understand The Market
The forex market is based on the concept of currency exchange, as you trade one currency for another. These currencies are affected by different factors. To know and analyze these factors you need to have deeper knowledge about market drivers. Spend some time learning about technical analysis and Fundamental analysis. The better you understand the market, the more successful your trades will be. Read more on How to Learn Forex Trading: the Detailed Guide for Beginners.
Control your Emotions
Trading in the forex market can trigger different overwhelming emotions like greed, anger, anxiety, or even fear. If you fail to get your emotions under control, you won’t be able to make good trading decisions, leading to losses. And as Warren Buffett once said: “If you cannot control your emotions, you can’t control your money.” Studying the different aspects of forex risk management can prevent irrational actions based on emotions.
Never Risk more than you can Afford
The golden rule in forex risk management is that you should never risk more than you can afford to lose. However, it is one of the most broken rules of money management ever. That’s because traders usually get tempted by the possible profits they can make, overlooking how significant the risks are. It is a very popular mistake among new traders specifically. This is why you should determine your risk tolerance; how much you can put at risk, or losing it.
Set a Risk-Reward Ratio
This is another important element of forex risk management. If you keep your losses limited, by minimizing the impact of potential risks, you will be able to stay in the market for a long time. This step helps you identify how much money you will risk per trade. By exceeding that amount, you are violating your own rules. Try to stick to the 1% common risk rate per trade. Never underestimate the importance of this step. You can also consider a proper risk-to-reward ratio of 1:2 or 1:3, meaning that potential profit should be triple or at least double the potential loss on the trade.
Use Stop Loss
The forex market is highly unpredictable especially when it comes to price volatility. That’s why using a stop loss order will help you minimize losses as possible if the market goes in the other direction. It is an essential rule in money and risk management. A Stop Loss order is used to automatically close a trade when the price reaches your set price level. It is usually placed with a market or a pending order.
Limit your Leverage
Leverage is using borrowed capital to maximize an investment’s potential return. It also gives traders the ability to increase the trading capital with a relatively small deposit, the margin. Despite its various advantages, it entails huge risks if not applied properly. High leverage may seem highly tempting as it magnifies the investment capital and potential profits, but what is always being overlooked is that it magnifies the possible losses as well. It is advised to choose the proper leverage level according to your experience, capital, goals, and risk tolerance.
The reason why traders take unnecessary risks is that they have unrealistic expectations of making money. Profiting in the forex market depends on different aspects, so try to have realistic expectations on how much money you can make. To be realistic, every trader should accept that trading is made up of winning and losing. Successful traders are the ones who can make steady returns, and manage their capital efficiently. Accepting failure is very important in forex trading. What’s important is to learn from your mistakes and avoid making them again.
Diversify your Portfolio
One of the most common classic techniques in risk management is to not put all your eggs in one basket. Diversifying your portfolio will minimize your risk exposure in case of high volatility. Experts always advise traders to diversify their trades to minimize the impact of volatility sudden changes. In forex risk management, a diversified trading portfolio remains one of the best rules.
Keep Up to Date
Another step to conduct forex risk management is to keep an eye on major events and data that may affect the market. Central bank decisions, political changes, market sentiment, and economic data have a direct impact on currency prices. By keeping up to date, you can always be a step ahead and expect potential risks.
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