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What is Risk Management in Forex Trading

According to prominent, and successful, traders one of the primary tasks of every trader is risk management. Some even say that traders are basically risk managers with a bit of an interest in financial markets. Although that might be an exaggeration, it is undeniable that even traders with brilliant performance records might end up losing money without a proper a risk management strategy. Risk management is a combination of multiple ideas to control your trading risk. It can be limiting your trade lot size, hedging, trading only during certain hours or days, or knowing when to take losses.

Risk management is one of the most key concepts to surviving as a forex trader. It is an easy concept to grasp for traders, but more difficult to actually apply. Brokers in the industry like to talk about the benefits of using leverage and keep the focus off of the drawbacks. This causes traders to come to the trading platform with the mindset that they should be taking a large risk and aim for the big bucks. It seems all too easy for those that have done it with a demo account, but once real money and emotions come in, things change. This is where true risk management is important.

For starters, trading always has an element of uncertainty, as no one can possibly foresee future events that might affect the price of the traded asset. But predicting the future is not the goal of trading in the first place. Predicting the probabilities of future price movements is the real goal of a trader, and this leads to the conclusion that you don’t trade because you are sure of what is going to happen. With that in mind, it is easy to see that you have to prepare yourself for losses, even with the most successful and reliable strategies. This means that you have to have a risk-management strategy before you start trading and entering positions.

It is often seen that on one hand, the traders want to reduce the size of potential loss but at the same time, some traders want to make a profit through getting the most out of a single trade. In addition to that, it is also true that one has to take greater risks in order to get high returns. It is often stated by the experts, and it is true indeed that forex trading market is not so easy to compete in – no matter how good is the trader, the fact always remains that it is the riskiest business platform. So without having proper forex market risk management no one will be able to survive for long in this business.

Risk is inherent in every trade you take, but as long as you can measure risk you can manage it. Just don’t overlook the fact that risk can be magnified by using too much leverage in respect to your trading capital as well as being magnified by a lack of liquidity in the market. With a disciplined approach and good trading habits, taking on some risk is the only way to generate good rewards. Managing your risk is vital if you want to succeed as a forex trader. This is why you should adhere to the aforementioned principles of forex risk management.

What is Forex Risk Management? Learn the Basics

Effective forex risk management allows currency traders to minimize losses that occur as a result of exchange rate fluctuations. Consequently, having a proper forex risk management plan in place can make for safer, more controlled and less stressful currency trading. In this piece, we cover the fundamentals of fx risk management and how best to incorporate them into your process.

What is forex risk management?

Forex risk management comprises individual actions that allow traders to protect against the downside of a trade. More risk means higher chance of sizeable returns – but also a greater chance of significant losses. Therefore, being able to manage the levels of risk to minimize loss, while maximizing gains, is a key skill for any trader to have.

How does a trader do this? Risk management can include establishing the correct position size, setting stop losses, and controlling emotions when entering and exiting positions. Implemented well, these measures can prove to be the difference between profitable trading and losing it all.

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Top 5 Fundamentals of Forex Risk Management

1. A ppetite for R isk

Working out yo ur app etite for risk is central to proper forex risk management. Traders should ask: How much am I willing to lose in a single trade? This is particularly important for the most volatile currency pairs , such as certain emerging market currencies . Also, liquidity in forex trading is a factor that affects risk management, as less liquid currency pairs may mean it is harder to enter and exit positions at the price you want.

If you don’t know how much you are comfortable with losing, your position size may end up too high, resulting in losses that may affect your ability to take on the next trade – or worse.

Let’s say 50% of your trades are winners. In the long term, mathematically you can expect to have runs of multiple losing trades in a row. Over a trading career of 10,000 trades, the odds suggest that you will face 13 sequential losses at some point. This underlines the importance of knowing your appetite for risk, as you need to be prepared, with sufficient money on your account, for when bad runs hit.

So how much should you risk? A good rule of thumb is to only risk between 1 and 3% of your account balance per trade. So, for example, if you have an account of $100,000, your risk amount would be $1,000-$3,000.

2. Position S ize

Selecting the right p osition size , or the number of lots you take on a trade, is important as the right size will both protect your account and maximize opportunities. To select your position size, you need to work out your stop placement, determine your risk percentage and evaluate your pip cost and lot size. For more on how to do these things, click on the link above.

3. S top L osses

Using stop loss orders – which are placed to close a trade when a specific price is reached – is another key concept to understand for effective risk management in forex trading. Knowing the point in advance at which you want to exit a position means you can prevent potentially significant losses. But where is this point? Broadly, it’s whatever point your initial trading idea is invalidated. For more detail on this concept, click on the ‘Using stop loss orders’ link above.

Traders should use stops and also limits to enforce a risk/reward ratio of 1:1 or higher. For 1:1, this means you are risking $1 to potentially make $1. Place a stop and a limit on each trade, ensuring that the limit is at least as far away from current market price as your stop.

The table shows how the outcomes of different risk-reward ratios can change a strategy:

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Forex risk management is one of the most debated topics in trading. On one hand, traders want to reduce the size of their potential losses, but on the other hand, traders also want to benefit by getting the most potential profit out of each trade. And there’s a common belief that in order to gain the highest returns, you need to take greater risks.

The reason many traders lose money in Forex isn’t simply inexperience – it’s poor risk management. Due to its volatility, the Forex market is inherently risky. Risk management in Forex is therefore a non-negotiable success factor for both beginners and experienced traders alike.

This is where the question of proper risk management arises. In this article, we will discuss Forex risk management and how to manage Forex risk when trading, including our top 10 risk management tips. This can help you to avoid losses, make more profits, and have a lower-stress trading experience.

The first step to Forex risk management – understanding Forex risk

The Forex market is one of the biggest financial markets on the planet, with everyday transactions totalling more than 5.1 trillion US dollars. Banks, financial establishments, and individual investors therefore have the potential to make huge profits and losses.

Forex trading risk is simply the potential risk of loss that may occur when trading. These risks might include:

  • Market risk: This is the risk of the financial market performing differently to how you expect, and is the most common risk in Forex trading. If you believe the US dollar will increase against the Euro and you buy the EURUSD currency pair only for it to fall, you will lose money.
  • Leverage risk: Because most Forex traders use leverage to open trades that are much larger than the size of their deposit, in some cases it’s even possible to lose more money than you initially deposited.
  • Interest rate risk: An economy’s interest rate can have an impact on the value of that economy’s currency, which means traders can be at risk of unexpected interest rate changes.
  • Liquidity risk: Some currencies are more liquid than others. This means there’s more supply and demand for them, and trades can be executed very quickly. For currencies where there is less demand, there might be a delay between you opening or closing a trade in your trading platform, and that trade being executed. This might mean that the trade isn’t executed at the expected price, and you make a smaller profit (or even lose money) as a result.
  • Risk of ruin: This is the risk of you running out of capital to execute trades. Just imagine that you have a long-term strategy for how you think a currency’s value will change, but it moves in the opposite direction. You need enough capital on your account to withstand that move until the currency moves in the direction you want. If you don’t have enough capital, your trade could be closed out automatically and you lose everything you’ve invested in that trade, even if the currency later moves in the direction you expected.

As you can see, there are a number of risks that come with Forex trading! For this reason, the topic of managing your Forex risk is very important. This is why we’ve put together our top 10 Forex risk management tips in this article.

10 Forex risk management tips

Here are our top 10 Forex risk management tips, which will help you reduce your Forex risk regardless of whether you’re a new trader or a pro:

  1. Educate yourself about Forex risk and trading
  2. Control your risk with a stop loss
  3. Don’t risk more than you can afford to lose
  4. Limit your use of leverage
  5. Have realistic profit expectations
  6. Use take profits to secure profits
  7. Have a Forex trading plan
  8. Prepare for the worst
  9. Manage Forex risk by managing your emotions
  10. Diversify your Forex portfolio

Tip 1. Educate yourself about Forex risk and trading

If you are just starting out, you will need to educate yourself. One attitude that will help is to approach Forex trading just as you would with any career, because that’s what it is.

The good news is that there are a wide range of educational resources that can help, including Forex articles, videos and webinars. And when you’re ready to start putting your new knowledge to the test, you can trade Forex using virtual funds in a free demo trading account.

A free demo account allows you to trade the markets risk free. This allows you to understand the trading platform, how the Forex market works and test different trading strategies.

Simply click the banner below to sign up for your free demo account today!

Tip 2. Manage your Forex risk with a stop loss

A stop loss is a tool to protect your trades from unexpected shifts in the market. Simply, it is a predefined price at which your trade will automatically close. So if you open a trade in the hope that an asset will increase in value, and it decreases, when the asset hits your stop loss price, the trade will close and it will prevent further losses. (Just note that stop losses aren’t a guarantee – there can be cases where there are gaps in prices when an asset won’t hit the stop loss, meaning the trade doesn’t close.)

Trading without a stop loss is like driving a car with no brake at top speed – it’s not going to end well.

A good rule of thumb is to set your stop loss at a level that means you will lose no more than 2% of your trading balance for any given trade. Let’s say you have a trading balance of $20,000. Your stop loss should be about 40 pips for a trade, so that if the trade goes against you, all you lose at your stop loss will be $80.

Once you’ve set your stop loss, you should never increase the loss margin. There’s no point having a safety net in place if you aren’t going to use it properly.

There are different types of stops in Forex. How you place your stop loss will depend on your personality and experience. Common types of stops include:

If you find you are always losing with a stop-loss, analyse your stops and see how many of them were actually useful. It might simply be time to adjust your levels to get better trading results.

In addition, a protective stop can help you lock in profits before the market turns. For example, once you have opened a position and have a floating profit of $500, you can move your stop loss closer to the current price, so that if it was hit, your trade would close with a profit of $400. If the trade keeps going your way, you can continue trailing the stop after the price. One automated way to do this is with trailing stops.

To learn how to set stop losses and take profits in MetaTrader 5, watch the video below:

Tip 3. Don’t risk more than you can afford to lose

One of the fundamental rules of risk management in the Forex market is that you should never risk more than you can afford to lose. That being said, this mistake is extremely common, especially among Forex traders just starting out. The Forex market is highly unpredictable, so traders who are willing to put in more than they can actually afford make themselves very vulnerable to Forex risks.

If a small sequence of losses would be enough to eradicate most of your trading capital, it suggests that each trade is taking on too much risk.

The process of covering lost Forex capital is difficult, as you have to make back a greater percentage of your trading account to cover what you lost. Imagine having a trading account of $5,000, and you lose $1,000. The percentage loss is 20%. To cover that loss, however, you need to get a profit of 25% with the same amount (as you only have $4,000 left on your account, a $1,000 profit is 25% of your new account balance). This is why you should calculate the risk involved in Forex trading before you start trading. If the chances of profit are lower in comparison to the profit to gain, stop trading. You may want to use a trading calculator to measure the risks more effectively.

A tried and tested rule is to not risk more than 2% of your account balance per trade. As mentioned earlier, for a $20,000 trading account that would be just $80. In addition, many traders adjust their position size to reflect the volatility of the pair they are trading. With that in mind, a more volatile currency demands a smaller position compared to a less volatile pair.

At some point, you may suffer a bad loss or a burn through a substantial portion of your trading capital. There is a temptation after a big loss to try and get your investment back with the next trade. But here’s a problem – increasing your risk when your account balance is already low is the worst time to do it. Instead, consider reducing your trading size in a losing streak, or taking a break until you can identify a high-probability trade. Always stay on an even keel, both emotionally and in terms of your position sizes.

To learn more about trading through a losing streak, check out the free webinar below with professional trader Jens Klatt:

Tip 4. Manage Forex risk by limiting your use of leverage

Linked to the previous Forex risk management tip is limiting your use of leverage.

Leverage, in a nutshell, offers you the opportunity to magnify profits made from your trading account, but it also increases the potential for risk.For example: leverage of 1:200 on a $400 account means that you can place a trade for up $80,000 ($400 x 200). On the other hand, applying leverage of 1:500 means that you can trade up to $200,000 ($400 x 500).

This then means that should your trade move in your favour, you are experiencing the full impact of the movement of that $80,000 (or $200,000) trade, even though you only invested $400. While this can mean large profits when the market moves in your favour, the risks are just as high.

Your level of exposure to risk is therefore higher with a higher leverage. If you are a beginner, avoid high leverage. Consider only using leverage when you have a clear understanding of the potential losses. If you do, you will not suffer major losses to your portfolio – and you can avoid being on the wrong side of the market.

Admiral Markets offers different leverages according to trader status. Traders come under two categories: retail traders and professional traders. Admiral Markets offers leverage of 1:30 for retail traders, and leverage of 1:500 for professional traders.There are benefits and trade offs to both, and you can find out what is available to you with our retail and professional terms.

Forex risk management is not hard to understand. The tricky part is having enough self-discipline to abide by these risk management rules when the market moves against a position.

Tip 5. Have realistic profit expectations to manage risk

One of the reasons that new traders are overly aggressive is because their expectations are not realistic. They may think that aggressive trading will help them make a return on their investment more quickly. However, the best traders make steady returns. Setting realistic goals and maintaining a conservative approach is the right way to start trading.

Being realistic goes hand in hand with admitting when you are wrong. It’s essential to exit quickly when there’s clear evidence that you have made a bad trade. It’s a natural human tendency to try and turn a bad situation into a good situation, but it’s a mistake in FX trading.

With this mindset, you can prevent greed from coming into the equation. Greed can lead you to make poor trading decisions. Trading is not about opening a winning trade every minute or so, it is about opening the right trades at the right time – and closing such trades prematurely if they proved to be wrong. Always try to maintain discipline and follow these Forex risk management strategies. This way, you will be in the best position to improve your trading.

Tip 6. Manage Forex risk with take profits

Once you have clear expectations, one way to secure your profits is by using a take profit. This is a similar tool to a stop loss, but with the opposite purpose – while a stop loss is designed to automatically close trades to prevent further losses, a take profit is designed to automatically close trades when they hit a certain profit level.

By having clear expectations for each trade, not only can you set a profit target (and a take profit), but you can also decide what an appropriate level of risk is for the trade. Most trades would aim for at least a 2:1 reward-to-risk ratio, where the expected reward (or profit) is twice the risk they are willing to take on a trade.

You would set your take profit at your target profit level (let’s say, 40 pips), and your stop loss would be half that distance from the opening price of your trade (in this case, 20 pips).

In short, think about what levels you are aiming for on the upside, and what level of loss is sensible to withstand on the downside. Doing so will help you to maintain your discipline in the heat of the trade. It will also encourage you to think in terms of risk versus reward.

Tip 7: Have a Forex trading plan for better risk management

One of the big mistakes new traders make is signing into the trading platform and then making a trade based on instinct, or what they heard in the news that day. While this might lead to a couple of lucky trades, that’s all they are – luck.

To properly manage your Forex risk, you need a trading plan that outlines:

  • When you will open a trade
  • When you will close it
  • Your minimum reward-to-risk ratio
  • The percentage of your account you are willing to risk per trade
  • And more

Have a Forex trading plan and stick to it in all situations. A trading plan will help keep your emotions in check and will also prevent you from over trading. With a plan, your entry and exit strategies are clearly defined – and you know when to take your gains or cut your losses without becoming fearful or greedy. This brings discipline into your trading, which is essential for successful Forex risk management.

It stands to reason that the success or failure of any trading system will be determined by its performance in the long term. So be wary of apportioning too much importance to the success or failure of your current trade. Do not bend or ignore the rules of your system to make your current trade work.

One of the best ways to create a trading plan is to learn from the experts. Did you know you can do this for free with our weekly webinars? Click the banner below to find out more and register!

Tip 8. Manage risk by being prepared for the worst

No one can predict the Forex market, but we do have plenty of evidence from the past of how the markets react in certain situations. What has happened before may not be repeated, but it does show what is possible. Therefore, it’s important to look at the history of the currency pair you are trading. Think about what action you would need to take to protect yourself if a bad scenario were to happen again.

Don’t underestimate the chances of unexpected price movements occurring – you should have a plan for such a scenario. You don’t have to delve far into the past to find examples of price shocks. For instance, in January 2020 the Swiss Franc surged roughly 30% against the Euro in a matter of minutes.

Tip 9. Manage Forex risk by managing your emotions

Forex traders need to have the ability to control their emotions. If you cannot control your emotions, you won’t be able to reach a position where you can achieve the profits you want from trading.

Why? Because emotional traders struggle to stick to trading rules and strategies. Traders who are overly stubborn may not exit losing trades quickly enough, because they expect the market to turn in their favour.

When a trader realises their mistake, they need to leave the market, taking the smallest loss possible. Waiting too long may cause the trader to end up losing substantial capital. Once out, traders need to be patient and re-enter the market when a genuine opportunity presents itself.

Or traders who are emotional following a loss might make larger trades trying to recoup their losses, but increase their risk as a result. The opposite can happen when a trader has a winning streak – they might get cocky and stop following proper Forex risk management strategies.

Ultimately, don’t become stressed in the trading process. The best Forex risk management strategies rely on traders avoiding stress, and instead being comfortable with the amount of capital invested.

Tip 10. Diversify your Forex portfolio to manage risk

A classic risk management rule is not to put all your eggs in one basket, and Forex is no exception. By having a diverse range of investments, you protect yourself in cases where one market might drop – the drop will be compensated for by other markets that are experiencing stronger performance.

With this in mind, you can manage your Forex risk by ensuring that Forex is a portion of your portfolio, but not all of it. Another way you can expand is to exchange more than one money pair.

Bonus risk management tip for frequent Forex traders

If you trade frequently, there’s another tool you can use for managing your Forex risk.

One of the main ways of measuring and managing your risk exposure is by looking at the correlation of your FX trades. In stocks there is a common index known as ‘beta’, which shows how the stock is expected to perform depending on changes within the industry. Generally, when trading stocks and aiming to reduce risk, a trader would usually attempt to combine the stocks that would result in a compounded beta that equals zero – as some stocks have positive beta, and others have negative.

What is Forex correlation, and how can it help with risk management?

There is no beta in Forex trading, but there is correlation. The correlation shows us how changes within one currency pair are reflected in the changes within another currency pair. Generally speaking, if you are trading closely correlated currencies (such as EUR/USD and AUD/JPY), you may expect them to have a common trend. In other words, whenever EUR/USD goes down, you could also expect to see a downward trend in AUD/JPY.

So how can this help to measure Forex risk exposure? We all know that risk is mainly driven by margin. This is why you should mainly trade the pairs that don’t have strong positive or negative correlations, as you will simply waste your margin on the pairs that result in the same, or the opposite direction. As a rule, currency correlation is also different on various time frames. This is why you should look for an exact correlation on the time frame you are actually using.

You can manage your Forex risks much better when paying closer attention to the currency correlation, especially when it comes to Forex scalping. Whenever you are engaging a scalping strategy, you have to maximise your gains over a short period of time. This can only be achieved by not trapping your margins in the opposite-correlated assets. Managing your risk is vital if you want to succeed as a Forex trader. This is why you should adhere to the aforementioned principles of Forex risk management.

The question is, how can you measure the correlation of different currency pairs? This is simple with the free, MetaTrader Supreme Edition add-on for MetaTrader 4 and 5.

To access this, you’ll need to:

Then, when you open MetaTrader on your computer and sign into your trading account, the feature will be available automatically! Simply:

  1. Go to the Navigator window (by default this appears in the bottom-left corner of the screen)
  2. Click Expert Advisors
  3. Click Admiral – Correlation Matrix
  4. Click OK to open the matrix

Source: Admiral Markets MT5 Correlation Matrix

Then you will be able to see how different currency pairs correlate!

Forex risk management tips conclusion

Like all aspects of trading, what works best will vary according to your preferences as a trader. Some traders are willing to tolerate more risk than others. However, in most cases, these 10 tips can help you manage, and reduce, your trading risk:

  1. Educate yourself about Forex
  2. Trade with a stop loss
  3. Don’t risk more than you can afford to lose
  4. Limit your use of leverage
  5. Have realistic profit expectations
  6. Use take profits
  7. Have a Forex trading plan
  8. Prepare for the worst
  9. Manage Forex risk by managing your emotions
  10. Diversify your Forex portfolio

If you are a beginner trader, then no matter who you are, the best tip to reduce your risk is to start conservatively. We recommend practising new strategies, in a risk-free environment, with a free demo trading account.

Fortunately, you can start demo trading today with Admiral Markets! With our risk-free demo trading account, professional traders can test their strategies and perfect them without risking their money.

A demo account is the perfect place for a beginner trader to get comfortable with trading, or for seasoned traders to practice. Whatever the purpose may be, a demo account is a necessity for the modern trader. Open your FREE demo trading account today by clicking the banner below!

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

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