Forex Risk Management

Forex Risk Management img1

Risk management in trading is just as important as the use of different methods of analysis and various strategies. As a result of competent risk management, a trader will be able to not only protect his deposit from a failed set of circumstances or his own mistakes, but also to increase capital. Risk management on the Forex market is comprised of a set of rules, principles, and attitudes that relate to the risks in trading relative to potential profits, taking into account strategy, psychology and other important factors.

Risk management is closely related to money management as a whole, because in many ways its principles concern the management of the money that a trader can invest in his trade. However, risk management, in particular, has a rather narrow specification – the ratio of risk and potential profit. The rules of risk management on Forex may vary depending on the chosen strategy. For example, if a trader tries to multiply his deposit, his risks will be an order of magnitude higher than that of someone who works with the usual trending strategy. A scalper will not manage risks in the same way as a trader working in the medium-term mode.

All this makes risk management very flexible and variable, which does not diminish its importance. Incorrect risk ratios, inability to protect the deposit from errors in measuring the lot size and other similar factors can completely wipe out the capital of the trader. On the other hand, competent risk management can help a trader minimize the consequences of mistakes made. For instance, a trader incorrectly determined the entry point, and with the help of a trading diary, he understood in advance that an error had crept in somewhere in his strategy and reduced risks as a result. The drawdown, which was the result of his mistake, did not bring any significant damage, but the trader was able to find exactly where he made a mistake and worked this moment through by analyzing it. Correctly setting a signal to open a position, he will now be able to increase the risks so that the profit will also increase.

Approaches to Risk Management

There are two forms of risk management implementation:

  • Conservative. Means working with minimal risk.
  • Aggressive. It assumes an increase in risk for a proportionate increase in potential profits.

Risk management has a clear practical expression when working with stop-loss. It plays a crucial role in almost every trading strategy. Stop loss assumes that an order automatically closes a position when the market goes against the trader’s expectations and is bound to bring him losses. By placing the stop loss at a certain distance from the entry point against his own order, the trader measures how much he is willing to lose in case of an error or failure. Why not put a stop loss as close as possible to the entry point? The answer lies in the very essence of the market: the price of an asset is constantly fluctuating. Even if the trend is up, local minima will still form and vice versa. With a downward trend, prices rise to the level of local maxima, and sometimes false breakthroughs can be observed.

Therefore, if the stop loss is too close, the usually meaningless oscillation can close the deal with an accidental loss. On the other hand, the absence of a stop order (and, accordingly, risk management) means that the trader and his deposit are defenseless against an unexpected trend reversal, which can also occur. Remember, that the market is not only volatile, but also unpredictable.

Stop loss has an opposite – an order that closes the position upon earning a certain profit. It is called take profit. According to the classic rules of money management, it should be at a distance two or three times the distance between the entry point and stop-loss. This means that the potential profit is two to three times the potential losses. Therefore, if the stop loss is far from the entry point, take profit (being even further) allows you to earn a truly large amount. However, the risks increase proportionally. The task of risk management is to find the middle ground, when a trader should not be afraid of losing capital after 3-5 unsuccessful transactions in a row, but also earn enough money according to the goals that were previously set and formulated.

Psychological Aspects of Risk Management

The psychological aspect of risk management plays a crucial role in trading. In order to trade effectively, a trader needs to have a correct perception of the market, directly related to risk management.

First of all, it is necessary to perceive trading as a profession. A lot is not a bet, but an investment. The trader predicts the development of events on the market for the selected instrument according to the conclusions made on the basis of fundamental, technical and mental analysis. After, he invests part of his money into his own idea and vision. Each order is like a small project for the trader, rather than a part of his game. A bit of luck, of course, is always welcome, because the market is unpredictable.

Immediately you want to impose restrictions on the influence of emotions on your actions as a trader. Trading real money, especially at the initial stage, is a stressful factor. Everyone reacts to it in their own way. Someone is afraid of opening the next deal after an unprofitable one, someone may fall under the influence of excitement, someone tries to get revenge on the market and act aggressively.

Clearly formulated risk management rules prevent the influence of these emotions on the trader’s behavior. The trader perceives the data more distantly, making it is easier to tolerate stress since he knows how he needs to react to a deposit drawdown or a profitable deal. Hence, it is very important that the risk management strategy is formulated clearly and completely, consistent with the overall trading system.

Core Risk Management Rules

  1. It is necessary to calculate the acceptable risks while taking into account how much it will be psychologically easier to lose. It is important that the drawdown does not affect the behavior of the trader and does not cause errors related to stress.
  2. The second core rule of risk management concerns the comparison of potential losses with potential profit. As already mentioned, take profit should be two or three times higher than the stop loss.
  3. The third rule concerns discipline. If the stop loss and take profit were set by proper analysis, they should be used, not ignored. You cannot close the deal before the price reaches the take profit. Do not improvise and change the location of the stop-loss.

Obviously, if an error really crept into the calculations of the stop loss and take profit level, then, of course, you need to change the risk management principles, but only by understanding how. This is where trade diaries come in. After analyzing the results of his work, the trader can find possible errors, omissions, unaccounted factors that influenced the market. This will allow him to make the changes he needs.

Any strategy must allow for drawdowns due to randomness or unrecorded factors. Often enough a trader, faced with a failure, violates the long-term rules of risk management that he himself has been working on by caving into his feelings. A huge mistake.

Risk Management in Action

Each losing trade should not take up more than 2-5% of the deposit. In the most extreme cases, you should only go up to 10%. Take profit should be two or three times the stop loss. This is a basic principle that is relevant to most strategies. It can be violated, and you can allow the ratio of 1 to 1 or even a greater loss than profit only if the number of successfully closed transactions exceeds orders of loss by several orders of magnitude. Of course, you want to test this with a demo account before committing actual money.

If the previous two orders closed at a loss because the price turned around, without reaching the take profit, this does not mean that you need to frantically close the next position without allowing it to bring the long-awaited level of income. Haste is just as harmful as ignoring errors. As a matter of fact, that is why the rule of 2-5% of the possible losses from the deposit on the transaction was formulated – to enable the strategy to demonstrate itself to its full potential on a series of orders. If there were no errors, after 2-3 losing trades in a row expect profitable ones to begin. Just make sure you have enough capital to open them.

Combining Trading Strategies and Risk Management

Sometimes in the strategies description, separately indicated lies an explanation of what risk management should be like. If that is not the case, you need to adhere to the following rules:

  • The sum of all losses on trades opened at the same time should not exceed 10-15% of the deposit. This is a universal rule for most mid-term trading strategies, which is also relevant for intraday trading.
  • An exception is the multiplier strategy. It is used when a trader comes in with a small deposit. By trading as aggressively as possible, he either loses all the money or gets a significant increase in capital, with the help of which he can switch to more moderate risk management while earning acceptable profits. Then the amount of possible losses varies around 30%.
  • Scalping strategies are interesting because with active trading they allow you to earn on a stable basis, opening up a whole series of short-term positions along a strong trend, cutting off small pieces of profit from it. Risks should be small, since the spread already reduces income.

Calculating Risk

Typically, the trader calculates 5% of his working capital, and then allocates this amount per lot. This is a mistake, as it is necessary to take into account such factors as the cost of each item, the spread and the possible transfer of the order to the next day, which will be accompanied by a positive or negative swap. Only by making calculations taking into account these factors, the trader will be able to understand the real risks in case of a drawdown. And this, in turn, will allow him to correctly set a stop loss.

To calculate the specific risks, you need to measure the value of the stop loss and the value of the item. That, in turn, depends on the leverage. If it is 100:1, this means that for every thousand USD of trader’s deposit, the broker agrees to provide him with 100,000. Suppose a trader trades a full lot. Then he can buy or sell, putting a long or short position in the amount of $100,000. On the trader’s account, the broker freezes that thousand as collateral. Regardless of whether the order is profitable or unprofitable, after its closure, this amount will be unfrozen. The main thing here is that the rest of the deposit is big enough to cover the losses, should there be any.

So, if the lot is equal to one, then each item costs about $10. Hence, if the stop loss is set at 10 points from the entry point, and the deal closes on it, the trader loses $100. If in 40 points – $400. If there is no stop loss at all, or it allows for even greater losses, the broker ensures that potential losses on all open trades do not exceed 70-80% of the working capital. As soon as this excess occurs, all transactions are automatically closed, due to which the trader, on the one hand, loses almost the entire deposit, and on the other avoids a situation where he still owes something to the broker.

An example of calculating the level of stop-loss. Suppose a trader’s deposit is $2000. Leverage is the same 100:1. The trader, wanting to reduce risks, trades a mini lot of 0.1, where each item costs $1.

Remembering that the potential loss from a single transaction should not exceed 5% of the deposit ($100 for the specified deposit), the trader can afford to set a stop loss at 90 points from the entry point. If the deal closes with a loss, it will not exceed those 5%. If it closes with a profit, then, since the take profit is two or three times the stop loss, the trader will receive $180-$270. Why 90 points and not 100? Ten points are taken as stock because the trader also has to pay the spread (commission to the broker), and if the transaction is open longer than one working day, it can also be spent on a swap.

Recommendations

Successful loss restriction occurs due to a combination of a number of factors:

  • Careful trading during the time frame that news is released.
  • The balance between diversification and concentration of funds in trade between assets.
  • Saving a moderate amount of open trades at one time.
  • Forex risk management strategies include:

  • Work only with highly liquid instruments.
  • Work based on the trends.
  • Important macroeconomic news always provokes an increase in market volatility, so you need to treat them with caution. Diversification involves investing in different assets. Exclusive concentration on one instrument limits the trader, but you should not be diversifying left and right in the beginning, unless you have significant capital to work with.

    As for the moderate number of open transactions, the total amount of losses on them should not exceed 10-30% from the deposit (depending on the strategy), and the number of open orders should be correlated with this.

    Risk management in Forex also implies the correct behavior in cases of unforeseen technical difficulties. For example, in case something happens to your computer, you need to download the mobile version of the trading platform in advance and learn how to work with it. Additionally, knowing how and where to contact the broker as fast as possible is highly recommended, considering the high stakes game that Forex is, speed and timing are paramount.

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