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In the ever-changing world of currency trading, mastering risk management is a fundamental skill set required for long-term success.
While currency values are ever-changing in the Forex market (sometimes referred to as the ‘foreign exchange market’), experienced traders understand the need to apply suitable risk management measures, alongside having an understanding of trading psychology as well as possessing analytical skills (technical analysis and fundamental analysis, for example) and ultimately working with a well-defined trading plan (this should cover everything needed to navigate and trade the financial markets, such as strategies employed and risk management).
Effective Forex risk management helps currency traders minimise risk; from an understanding of how to set protective stop-loss orders to how leverage and position sizing work, having a solid Forex risk management strategy in place can lead to more controllable and less stressful trading.
As the name suggests, a protective stop-loss order is a predefined command a trader sends to their broker to close the trade when the price hits a specific threshold. Its primary role is to prevent further downside by discontinuing an active trading position.
For example, a buy position (long) on the EUR/USD at $1.3051 with a 10-pip stop involves the trader setting a protective stop-loss order beneath the current price action: $1.3041. If price movement trades unfavourably and the bid hits $1.3041, the trade will be liquidated at the next available market price. This would result in a loss of 10 pips (minus commissions and any slippage [this is the difference between the desired price and the price received]).
Protective stop-loss orders are important as they not only assist traders in adhering to their risk management plans but also serve as a safety net, helping to ensure things are kept within predetermined limits if/when the markets shift against the trader.
The subject of leverage and position sizing can be confusing for new traders.
Forex traders rely heavily on position sizing to manage risk and maximise gains. The position size represents the number of lots you trade (it is also sometimes referred to as ‘trading volume’ or ‘units traded’). Although you can employ the use of Forex calculators to compute position size, understanding the manual calculation is recommended. How one computes their position size depends on the currency pair traded, the predefined risk per trade, the stop distance in pips and account currency.
For example, if you enter long on the GBP/USD pair at $1.1235 and set a stop-loss at $1.1225, you risk 10 pips. Now, imagine your account is denominated in USD and the account equity is currently 10,000 USD, and you have decided to risk 2% of your account equity on each trade (200 USD).
When an account currency matches the quote currency of the pair traded, the calculation is straightforward:
Position Size: Risk / Stop-Loss Distance
Therefore, in the case above, we simply divide 200 by 0.0010 to get 200,000 units, or two standard lots, which on MetaTrader would be entered as ‘2.00’ in the volume tab.
You can learn how to calculate your position size for different currencies manually here. As for leverage, this is fixed as a specific ratio and does not fluctuate (your effective leverage, however, does vary, which is calculated by dividing your account equity by the number of units traded). To understand leverage, you must understand margin, as the two concepts are closely related. The primary purpose of leverage is to determine the margin required to execute a trade, and by using margin you effectively leverage your position x amount of the margin.
The risk-reward ratio calculates anticipated gains and risks from trades. The trader determines and uses it to specify the amount they are ready to risk and expect to gain from each trade.
It is calculated using the formula:
Risk-reward ratio = (Entry Point – Stop-Loss Point) / (Take-Profit Point – Entry Point)
Suppose you long EUR/USD at an entry point of $1.3056. If you fix a stop-loss at $1.3046 and a take-profit point at $1.3076, the risk/reward ratio would be calculated as follows:
Risk-Reward Ratio = (1.3056 – 1.3046) / (1.3076 – 1.3056) = 0.5 (or 1:2)
In most cases, it is recommended to aim to keep the risk-reward ratio between 1:2 and 1:3. This is because when the trading strategy experiences consecutive losses (every method does), the gains from winning trades should offset any losses.
If the ratio exceeds 1.0, the risk outweighs the gain. If the ratio is less than 1.0, the reward is greater than the risk. Successful traders aim for the latter and generally avoid trades offering less.
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