To understand the Risk associated with Forex and Risk Management, we need to understand why Forex is risky.
What is Forex Risk?
Forex is a very lucrative but highly risky business. Traders all over the world participate and everyday transactions exceed 1.4 trillion US dollars. The risk is higher as the profit and loss occurred quickly due to the volatility and human psychology play a vital role in driving the prices in markets.
To minimize vital losses, traders use different money management and risk management techniques. I’ll share with you some of them in this article.
Simple mistakes to risk management causes major loses
One of the common mistakes a trader do is to execute trade without calculating proper risk and also the exit point. This is extremely common and most repeatedly mistake and in many cases accumulate bigger losses or even wiping their entire trading accounts.
Forex market is highly volatile and unpredictable. The prices are affected by many factors this includes news, governments, sentiments, and economical figures. So this volatility brings the huge risk of changing the price from negative to positive or vice versa quickly. Successful traders always advise not to invest more than 1 to 2% per trade. Equity protection is their number 1 priority and money-making is second!
What is Forex Risk Management and Trade Management Psychology
Forex Risk management is all about defining Risk of Trade before executing it. In other words, how much money we are willing to Risk to gain Reward/Gain. Successful traders take a very conservative approach when it comes to investing in Forex. At any given time, they usually trade between 1 to 2% of total equality. There are certain money management strategies as well but we will cover them separately.
So let’s take a quick example. Let’s say your balance is $10,000 and we are willing to risk 2% of the equity (total balance). The formula would be
10,000 X 2% = $200
So this will give us the amount ($200) we want to invest per trade. To be a successful trader, your Risk and Reward ratio should be double at least and mostly it’s 3% and above. Let’s say you want to risk 1% of your equity to make a 3% return (minimum).
This is relative and totally depends upon the trader approach. As you are familiar with different types of traders Swing Trader, Intraday Trader, Scalpers and many more! But each has its own risk appetite to gain successive rewards.
Let’s take a mathematical approach to understand this. Let’s say you want to invest 1% to get a 10% return. You have $100 equity and each time you risk $1 for trade. This means you have to be right only 11 times and still be profitable. You took 100 Trades and in which 89 Trades were just pure losses. You won’t only 11 times and that gives you a profit of 110 which means you have added $10 in your account. The downside of this strategy is the draw-down would be huge and the person has to manage the consecutive losses and their psychological effect on trading.
Here are few tips to mitigate Forex Risk and trade professionally.
- Always use stop loss
- Follow the trend cause Trend is your friend
- Don’t trade extremely positive or negative correlation pairs
- Never risk whole equity and always follow the rule of not investing more than 1-2% per trade.
- Don’t over leverage your trades. Leverage is double edge sword and can wipe out your trading account quickly.
Always Use Stop Loss
Always use stop loss when you execute trade or place pending trade. we will cover types of trades in some different article. Stop Loss is a price level which you identify before you execute trade. This price level act as exit point from trade.
Follow the Trend
The trend is your friend! always try to be on the correct side of the market. if there is a strong trend in progress, take trades in the direction of the trend. it will increase the probability of winning as compared to taking trade against the trend.
Avoid extremely positive or negative correlation
Study Forex pair and their anatomy. you will find certain Forex pairs are extremely positive correlate or negative correlate. Correlation means both currency pairs move or act similarly.
The following picture shows EURUSD and AUDUSD Chart with strong and positive correlation between both pairs.
A negative correlation in Forex means that both currency pair act total oppositely.
let’s take an example of EURUSD and USDCAD. For instance, you will find in the picture that both are moving in opposite directions.
now if we are trading with closely positive correlated pair, we know the both currency pairs will act similarly. In addition to this, if we take trades on two correlated pairs, this means our analysis has to be wrong for one and the other trade will be automatically hit our stop loss.
If we trade them in opposite direction then the profitable trade will offset the losses of negative trade and ultimately we will be losing money.