Seven Steps To Solid Risk Management In Forex Trading

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The world of forex trading is exciting and potentially lucrative, but it’s also a fast moving business, and traders need to be prepared for every twist and turn in the road. One of the cornerstones of a successful trading strategy is sound risk management. The most consistent profits come to those who manage risk carefully rather than take chances.

It is impossible to avoid making losses occasionally, and even the most experienced traders accept that losses are inevitable. However, smart trading is all about mitigating against the risk of losses, and that starts with solid risk management.

This may seem obvious but a lack of planning and preparation in this area is the downfall of many a newbie trader. Here are seven steps to building an effective risk management plan that will help to maximise your rewards and minimise your losses.

Understand the nature of risk in forex

First of all it is important to define what is meant by risk. The forex markets are highly liquid, meaning that currency pairs can be easily bought and sold and there is a high amount of trading activity. It trades almost 24/7 and has a daily turnover of about $6.6 trillion. This liquidity also influences how volatile the markets are.

Volatility in forex is the measure of how far the price of a currency pair fluctuates. If there are sudden sharp upswings or downturns in the market, it is said to have high volatility. If there is not much fluctuation of price, then the markets have low volatility.

The higher the level of volatility in the market, then the greater the level of risk, because drastic unexpected price movements significantly increase the chances of making a losing trade (and of making a profit). There are several different factors that can increase market volatility, so it’s important that you understand what these are and how to monitor them.

This will help you to take calculated risks that are based on probabilities, rather than guesswork or ‘instinct.’ Forex trading is not so much about natural talent and no one has a ‘gut instinct’ about a good trade: your decision making must be based on objective and well researched information at all times.

To protect your assets you need to be able to manage risk well, and have the emotional maturity and discipline to stick to your strategy in the face of rising panic. This can be easier said than done, because you will find that forex trading brings about intense emotional states such as fear, greed, anger and anxiety.

Even if you consider yourself to be immune to subjective influences, it is very easy to be taken by surprise or to make decisions based on unconsciously biassed thinking. When you are about to act in haste, put your ego to one side, and learn to step back and refer to your risk management plan. Without further ado, let’s look at how to put together a solid strategy.

Know your risk tolerance

The first step is to work out your risk tolerance. This means determining how much capital you are willing to risk on each trade. Newer traders are advised to risk no more than 1% or 2% of the total value of their account per trade. This will protect you from damaging losses while you are finding your feet and gaining experience.

The level of risk is also determined by how much capital you put into your account in the first place. This should always be disposable income or savings rather than money that you need to pay for life’s essentials.

Be realistic about the amount you can comfortably afford to lose and don’t stretch yourself beyond your means, because this will put you under too much psychological pressure and could lead to biassed and unwise decision making.

Use stop losses

Stop losses are tools that allow you to set in advance a price point at which a trade will exit the market. This will help you to avoid incurring damaging losses if the markets move against your expectations. No one can be right 100% of the time, so a stop loss acts as a kind of safety net should your currency pairs be caught up in market turbulence.

A stop loss will be automatically triggered once the predetermined price point is achieved, removing the temptation to hang on in there and hope for a change of fortune. Sometimes, you just need to cut your losses and run. We can all make wrong calls, especially when we are under pressure, so a stop loss removes temptation and contains the damage.

The stop loss order can be adjusted after the position has been opened, but most of the time it’s best to leave well alone unless you have a very sound reason to make a change that is aligned with your overall trading strategy.

Inexperienced traders often either exit a trade too early and fail to maximise on a profit, or hold out for a bigger profit, only for the market to turn and send the profit nose diving into a loss. Therefore stop losses are recommended as a standard risk management tool for all novice traders.

Be cautious with leverage

One of the reasons that so many people are attracted to forex trading is the high amount of leverage available. This is money loaned by the broker that allows you to trade with far larger positions than you would otherwise be able to.

It’s possible to open an account without a fairly small amount of capital and control positions many times the value of your deposit. For example, if the broker offers leverage of 100:1 then for an investment of $1,000 you can control a position to the value of $100,000. Some brokers will offer much higher leverage than this.

However, as you have probably already realised, these potentially higher rewards come with a higher risk. The best strategy is to start small because leverage is the most inherently risky aspect of forex trading. A leverage of 5:1 or lower is considered to be a manageable amount for new traders.

Before you start live trading, always test out your strategy on a demo account first. This will give you a chance to get familiar with the user interface of the trading platform and give you a taste of how well you can stick to your trading plan without any risk attached.

Keep up to date with economic events

The forex markets are influenced by a range of political and economic factors that affect the value of currency pairs. In particular, follow the news for reports of interest rate rises or decreases, inflation rate changes, unemployment levels, and the consumer price index. These are all indicators of how well an economy is doing.

Geopolitical events such as elections, wars, and natural disasters also affect currency value. This information should guide your choice of currency pairs and alert you to any potential market volatility, and is referred to as fundamental analysis.

Apply some technical analysis techniques

Technical analysis tools will help you to understand the dynamics of the market and make well informed decisions about future probabilities. This in turn will help you determine price points at which to enter and exit the market. Even technical analysis is not an exact science and you will need to make judgement calls based on fundamental analysis as well.

However, they are an essential tool to help measure risk and stack the odds of making a profitable trade in your favour. Line charts and bar graphs are straightforward to understand and will enable you to analyse historic price patterns and gauge probabilities for future movement.

There are many more complex technical strategies and tools that you use, so it’s worth investigating what these are and adopting ones that you feel confident about using. However, it’s still possible to be a profitable trader without a complex technical strategy, so don’t be daunted if this area is not your forte.

Learn to accept risk and deal with losses well

Finally, even experienced traders who have honed their risk management skills over several years still experience losses. It’s important to understand that it is not possible to eliminate risk entirely, and successful forex trading is all about minimising risk.

Good traders use losses as learning opportunities to see what might have gone wrong and what can be done to improve the situation next time. They do not regard losses as a sign of failure or react with shame, fear, or retaliate with revenge trading. They simply accept the loss as a business expense, take note of any points for future reference, and move on.

By adopting a similar approach and learning how to build your own effective risk management strategy, you will always have some degree of control over the outcome of your trades and will be well on your way to making steady and consistent profits.

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FTUK Funded Account Disclaimer

CFTC Rule 4.41 – Hypothetical or Simulated performance results have certain limitations. Unlike an actual performance record, simulated results do not represent actual trading. Also, because the trades have not actually been executed, the results may have under-or-over compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated trading programs, in general, are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profit or losses similar to those shown.

All our funded accounts come with a fixed equity stop out level. Once the account equity level gets below this fixed stop out bar, we will close all running trades and disable trading and access. The stop out level is a fixed value for each funding level, this means that any profit which has been made by the trader increases the loss allowance.

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