Losing traders are fascinated with the fact that the forex market moves 6.5trillion dollars a day; all they see is the opportunity to rake in just a little bit of the trillions flying around; what they forget is the risk of forex trading is real. The risk of losing everything you’ve got and more.
I could bet you, understanding forex risk management will save you years of frustration in the journey to consistent trading profits.
If there is anything you can learn about trading that will give you an edge and save your account in the long run, learn to manage forex trading risk.
Seriously, a good strategy is only good because of the risk buffer in it; trading psychology wouldn’t make sense if managing losses weren’t central to the workings of your mind.
I repeat, if there is anything to learn about forex trading, if there is anything to understand, then understand the importance of risk management in your trading.
In this guide, I will help you understand the concept of risk management and show you practical things you can do to manage risk in your trading.
Let’s dive in.
What is forex trading risk?
Forex trading risk is the likelihood of losing money from trading forex.
But that is a narrow way of looking at the risk of trading with margin.
The dictionary definition of risk, the verb, is to expose (someone or something valued) to danger, harm, or loss.
Now back to trading, what really is at risk? What is exposed to danger, harm, or loss by trading forex or stocks?
- You can add to the list.
So if you were thinking of what may go wrong by trading, don’t constrain your thoughts to money.
Yes, in the market, you directly risk losing money, and that’s why we focus on managing that risk, but the effects of trading lose ripple through every other area of your life with a domino effect.
That’s why it is uber important to understand risk in trading, appreciate its importance, and learn to proper risk management strategies that will save your ass when the market rage.
Types of trading risks
There are many risks to forex trading, some within your control and others not. Either way, know what risks you face and later formulate strategies that protect you.
The market risk stems from the markets’ natural behavior; any trade can lead to a profit or a loss.
The risk is, you enter a trade, say BTCUSD (that’s what I am trading as I write), you hope the candles will tick lower, but instead, they go higher, resulting in a loss.
Market risk is the risk of losing money when the market goes against your projections.
The attraction of margin trading is leverage – the ability to take on a larger position with little capital.
With 1:100 leverage, a $1000 account can open a position worth $100,000. That means you can make money fast, but with market risk in mind, the risk of leverage is that you can quickly lose all your money since you are trading with a large volume for your capital to absorb the downside.
Transactional and System Risk
Trading requires one to provide instructions to open or close a trade. That can mean placing a call to the trading desk, sending an email, or hitting the bid/ask button on a trading platform.
What if the instruction does not reach in time? What if the system fails and your stop-loss limit does not hold?
Anything can happen with the system that results in you losing money.
Institutional and Counterparty Risk
Several institutions ensure you can trade: Banks, forex brokers, payment processors, etc.
A forex broker may be a fraud, or the forex broker or bank may go bankrupt, and just like that, you lose all your money.
In events like this, the deposit insurance, if any, barely covers all customer deposits held by the broker or bank.
The forex market is darling to traders because of liquidity. There’s more money in the forex market than in any other market like the stock market.
But every once in awhile, liquidity nearly dries down either as a result of a geopolitical or central bank event or when there are few market participants.
As a result, brokers may widen spreads or halt trading an instrument altogether.
Increased spreads mean increased trading costs, which means you risk losing money as liquidity fluctuates.
Risk of Ruin
How much does price have to move against you before you lose all the money in the account? That’s the risk of ruin.
Brokers require you to maintain a level of free margin to execute trades or keep current trades running; if you fall below the margin level, they close the trade. Depending on your leverage, the trades are closed when the running trade is in negatives to your account’s amount.
Say you have a $10,000 account – trading on 1:10 leverage – that means a trade has to go 1000 pips against you on full leverage. In terms of pips, your risk of ruin is 1000 pips.
The demand and supply of a currency or trading instrument are ultimately driven by fundamental factors beyond a normal trader’s control.
Elections, wars, political instabilities, among other factors, impact the value of currencies. If you are trading the country’s currency in a political situation, you risk losing your money.
Interest Rate Risk
The interest rate is one of the tools Central Banks uses to steer an economy in a particular direction.
This directly impacts the value of a currency.
A long position of any currency pair with the USD or any instrument pegged to the US dollar may result in severe losses of existing trades when the Fed decides to cut interest rates.
Now that you know the risks you face as a trader let’s look at how to manage trading risks.
What is forex trading risk management?
Forex risk management is the process of identifying and controlling how much you can lose in a trade.
Importance of forex risk management?
Without trading risk management, you are guaranteed to lose your money. That is a fact.
If avoiding losing money is not reason enough to embrace the importance of forex trading risk management, then I don’t know what else will.
It is a guaranteed likelihood, a certain possibility that every trade you enter will either turn to profit or a loss.
Therefore, it is ostrich-foolishness to bury your head in the sand and ignore the possibility that you may lose money in that trade you don’t want to manage right.
How to manage forex trading risk
These forex risk management strategies will protect you against the forex trading risks above.
Hold onto them with dear life, and you will reap the profits of trading.
Have a trading plan and a strategy
A trading strategy and a trading plan help traders stay sane in the jungle of the forex market.
Without a trading strategy and a plan, you will never know trade setups and conditions you need to enter or exit a trade.
You can’t wing your way to trading success. That is gambling.
Use a stop-loss limit
If you don’t set how much you are willing to lose on each trade, you are subconsciously willing to lose every penny in your trading account.
If that is not your intention, always place a stop-loss limit with every trade you enter.
Market risk and fundamental risks don’t respect even the best-formulated plan or strategy; when you are wrong on a trade direction, a stop-loss protects your account from the risk of ruin.
Trade with money you are willing to lose
Some risks will not respect your stop-loss limit. Even the most disciplined trader has days when they break their trading rules or a black-swan even drops unannounced. All it takes is one trade to test your risk of ruin.
That is why you should only play the markets with money you are willing to lose.
Be careful with leverage
Leverage is a double-edged sword; it slices whichever side it swings.
In your direction, it will give you a chunk of profits fast against you; it will suck all your funds.
If two traders have a $1000 trading account each, trader A trades with 1:10 and trader B trades with 1:500 leverage.
Who do you think is most likely to lose his money? Trader B.
Trader A will only lose his account if he lets his trade go against him by 1000 pips, while trader B will lose their account in 20 pips
Choose a reliable forex broker
A reliable forex broker is regulated.
A reliable forex broker won’t go bankrupt overnight.
A reliable broker won’t close their website and run away with your money.
A reliable broker respects its promise on spreads and trading costs.
A reliable broker won’t give you a thousand reasons why you can’t withdraw your profits.
You need a reliable forex broker to mitigate many risks of forex trading.
Diversify your risks – trade with multiple brokers
Don’t put all your money in one broker; spread it around. Just in case one goes underbelly, you lose only part of your funds.
If you are copy trading, split your portfolio among different strategy providers