Top Risk Management Techniques in Forex Trading

Top Risk Management Techniques in Forex Trading

Reading time: 6 minutes

The impact of not understanding risk management can, in some cases, prove catastrophic. To help, the focus of this article will be centred on basic, common-sense risk management for traders in the foreign exchange market (Forex [FX] market).

Depending on whom you ask, risk could be defined as loosely as the amount of money at risk per trade, or, from more of a portfolio management side, risk could be quantified as a measure of how volatile a currency pair is according to the standard deviation: how spread out price action is from the central tendency or mean value.

Why is Risk Management Important?

Risk management is imperative for any Forex trader and any trading strategy in the Forex market. No trading system has ever been 100% profitable on each trade, and the threat of account ruin for uninformed traders is ever-present.

The importance of managing risk exposure in the financial markets, generally in the form of pre-defined rules, cannot be stressed enough. In fact, most professional traders suggest learning about risk and money management and trading psychology before examining methods to determine buy and sell signals. Unfortunately, it is often the other way around: traders begin implementing trading strategies void of a clear understanding of risk and trading psychology.

Protective Stop-Loss Orders

As the title suggests, the protective stop-loss order helps mitigate market risk, helping traders exit the market and avoid further loss beyond what is considered permissible according to the trader’s risk tolerance per trade. How a trader goes about positioning their protective stop-loss order will be dependent on the traders’ strategies. 

How one elects to set a stop-loss order could be as basic as a ‘technical stop’, a common approach that involves assessing the currency pair’s chart based on technical analysis. For example, one may locate their stops beyond support and resistance, pivot points, or the outer limits of some technical indicators, such as Bollinger Bands (a popular volatility indicator). 

Understand Position Sizing and Leverage

While you can calculate your effective leverage when trading (this is found by dividing your notional position size by your account equity [your current trading capital]), leverage will be fixed at a specific ratio, like 100:1 (meaning for every dollar in one’s trading account, they could effectively open a position 100 times that). Position sizing, however, is incredibly important to understand, and, although you can employ the use of the FP Markets Forex Calculator to compute your position size, it is recommended to understand the manual calculation. For example, imagine a trader who has an account denominated in US dollars (USD) and wants to trade the EUR/USD and risk 2% of an account at 10,000 USD (200 USD trade risk) using a 20-pip stop from the entry price, the position size would be 100,000 units of the base currency (euro) or one standard lot. This can be easily manually calculated in this instance by dividing trade risk (200) by the pip distance (0.0020), or simply use the FP Markets Forex Calculator, as shown below.

A Trading Plan

It has almost become a cliché, but trading without a plan is akin to driving at night with the lights off. This can eventually end in disaster for the trader (and driver). Some confuse a trading plan for a trading strategy. A trading plan encompasses everything one needs to trade in the market, including the trading strategies used. Among other things, aspects included within a trading plan should also be the risk-management plan (this should be clearly defined and adhered to at all times), together with any goals the trader has set out, FP Markets’ contact details in the event of the need to contact them, and other things to help monitor trading performance to aid with evaluation.

Demo Before Live

Another risk-management technique professional traders recommend new traders to consider is the use of a demo account. This is an account provided by FP Markets to enable traders to trade live data but use simulated funds. Not only will this help the newer entrant become familiar with their chosen trading platform, but it will also offer the trader the opportunity to begin testing their strategy and understanding how to implement their risk-management approach. 

Wrap Up

As this article shows, effective risk management requires attention to detail. Employing a well-defined risk-management strategy that covers as many angles as possible will help increase the odds of trading success, particularly if you combine it with trading strategies that have been validated through back-testing on historical data and forward-testing using out-of-sample data. 

While this may seem obvious, exposing your trading operations to unnecessary risk through lack of knowledge is unacceptable. While there are several other risk-management techniques available, the four techniques listed in this article should provide enough to work with for beginner traders and help limit downside risk when trading. Trading the markets is a never-ending journey of learning, and successful traders embrace this journey! 

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