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Forex Risk Management

Reading time: 8 minutes

Forex risk management is one of the most debated topics in trading. On one hand, traders want to reduce the size of a potential loss, but on the other hand, such traders also want to benefit by getting the most out of a single trade. It's no secret that in order to gain the highest returns, you need to take greater risks.

This is where the question of proper risk management arises. In this article, we will discuss Forex trading risk management and how to manage Forex risk when trading. This can help you to avoid loss, and completely engage in your trading activities without worry.

Risk Management In Forex Trading

What is Forex Risk?

The Forex market is one of the biggest financial markets on the planet, with everyday transactions totalling more than 1.4 trillion US dollars. Banks, financial establishments, and individual investors therefore have the potential to make huge profits and losses. Forex trade risk is simply the potential loss or profit which occurs as a result of a change in exchange rates. To minimise the likelihood of financial loss, each investor needs to have in place some Forex risk management actions, strategies, and precautions.

A lot of people today are engaged with trading activities within the foreign exchange market. However, most of them are not in a position to achieve the profits that they expect. Some traders will lose all of their money, while some fail to get the results they expected. In fact, only a small share of traders are ever able to meet or even surpass their expectations. The Forex market is constantly changing, and this brings great risks that all traders have to work with. Therefore, the topic of Forex trading risk control is an increasingly popular subject amongst Forex traders.

Common Mistakes in Managing Risk in Forex Trading

One of the fundamental ground rules of risk management in the Forex market is that you should never risk more than you can afford to lose. That being said, this mistake is extremely common, especially amongst Forex traders just starting out. The Forex market is highly unpredictable, so traders who are willing to put in more than they can actually afford make themselves very vulnerable to Forex risks.

Anything can affect the Forex market - the smallest piece of news can affect the price of a particular currency in a negative or a positive way. Instead of 'going all in', it is better to follow a more moderate path, and trade conservative amounts of capital.

Emotional Management Strategies and Risk

Forex traders need to have the ability to control their emotions. If you cannot control your emotions, you won't be able to reach a position where you can achieve the profits you want from trading. Market sentiment can often trap traders in volatile market positions. This is one of the most common Forex trading risks. Those who have a stubborn nature don't tend to perform well in the Forex market.

These types of traders tend to have a tendency to wait too long to exit a position. When a trader realises their mistake, they need to leave the market, taking the smallest loss possible. Waiting too long may cause the trader to end up losing substantial capital. Once out, traders need to be patient and re-enter the market when a genuine opportunity presents itself.

How to Get Better at Forex Risk Management

Fortunately, several methods are available to help Forex traders avoid these mistakes and to avoid loss. You should have a well-tested trading plan which includes all the details concerning risk management in Forex. The trading plan should be practical - and you should be able to follow its steps easily. Experts recommend that it is better to focus on higher probability trades.

The Forex trading industry contains a high level of risk, so it isn't necessarily the best discipline for all investors. You also need to be able to pay extra attention to mistakes, and engage in your trading activities on the foreign exchange market. The time and effort that you spend creating a trading plan is often considered as a great investment that will help towards a profitable future.

Basic Concepts

In order to reduce Forex trading risk, you'll need to remember some of the basic points which are listed below:

  • The valuation of money changes, and it often influences firms and people engaged with global exchanges
  • Liabilities, assets, and money streams are influenced through changes in exchange rates

By trading with small amounts of capital and monitoring market movements, you will be able to see these concepts take hold throughout the daily trading sessions.

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Forex Risk Management Tips

Below are a series of simple tips for Forex risk management which may help in reducing potential trading losses:

Stop-losses

Trading without a stop-loss is similar to driving a car with no brake at maximum speed - it's not going to end well. Similarly, once you've set your stop-loss, you should never bring it down. There's no point having a safety net in place if you aren't going to use it properly.

Don't tie all of your investments up in one place

This is applies to all types of investment, and Forex is no exception. Forex should account for a portion of your portfolio, but not all of it. Another way you can expand is to exchange more than one money pair.

The trend is your companion

You may have made the decision to be a position trader, with plans to hold that position for an extended period of time. However, no matter which position you have ultimately decided to take, you shouldn't fight current market trends or movements. There's always going to be stronger players in the market, and the best way you can keep up with them is by accommodating such changes, and altering your strategies to reflect this.

Keep teaching yourself

The best way to learn the risk management system in Forex and become an effective Forex trader is by knowing how the market functions. However, as mentioned previously, the market is constantly changing, so if you want to stay ahead of your game you have to be willing to always learn new things and update yourself on the market's changes.

Use software programs for help

To progress in Forex you may want to utilise certain trading software that can help you settle on your choices. That being said, these systems aren't perfect, so it's best to use them as an advisory tool, and something to fall back on, rather than using them as the basis for trading decisions.

Limit the use of leverage

It can be extremely tempting to use leverage to make significant profits. However, this can make it much easier for you to lose huge amounts of capital too. So don't take on gigantic leverages. All it takes is one quick change in the market, and you could easily wipe out your entire trading account. Forex risk management is not hard to understand. The tricky part is having enough self-discipline to abide by these risk management rules when the market moves against a position.

Risk Management for Frequent Traders

If you trade frequently, one of the main ways of measuring and managing your risk exposure is by looking at the correlation of your FX trades. In stocks there is a common index known as 'beta', which shows how the stock is expected to perform depending on changes within the industry. Generally, when trading stocks and aiming to reduce risk, a trader would usually attempt to combine the stocks that would result in a compounded beta that equals zero - as some stocks have positive beta, and others have negative.

What is correlation?

There is no beta in Forex trading, but there is correlation. The correlation shows us how changes within one currency pair are reflected in the changes within another currency pair. Generally speaking, if you are trading closely correlated currencies (such as EUR/USD and AUD/JPY), you may expect them to have a common trend. In other words, whenever EUR/USD goes down, you could also expect to see a downward trend in AUD/JPY.

So how can this help to measure Forex risk exposure? We all know that risk is mainly driven by margin. This is why you should mainly trade the pairs that don't have strong positive or negative correlations, as you will simply waste your margin on the pairs that result in the same, or the opposite direction. As a rule, currency correlation is also different on various time frames. This is why you should look for an exact correlation on the time frame you are actually using.

You can manage your Forex risks much better when paying closer attention to the currency correlation, especially when it comes to Forex scalping. Whenever you are engaging a scalping strategy, you have to maximise your gains over a short period of time. This can only be achieved by not trapping your margins in the opposite-correlated assets. Managing your risk is vital if you want to succeed as a Forex trader. This is why you should adhere to the aforementioned principles of Forex risk management.

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

Risk Warning

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 83% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.