Risk Management for Forex and CFD trading
Learn about the importance of good risk management for successful Forex and CFD trading.
Forex and Contracts for Difference (CFDs) are both traded using leverage, which allows traders to access larger positions for a smaller initial deposit. Whilst leverage enables traders to magnify their potential profits, it has the same magnifying effect on potential losses and, consequently, greatly increases the risks associated with trading.
In addition to leverage, there are many other Forex and CFD trading risks which exist. However, there are also various steps traders can take in order to minimise these risks as much as possible. In this article, we will guide you through the basics of risk management in Forex and CFD trading - demonstrating, not only its importance, but also practical ways in which you can implement Forex risk management strategies in your trading.
Before you start trading Forex or CFDs on the live markets, we recommend the following:
What is risk management?
General trading risks
Naturally, when it comes to trading, opportunities to profit come with associated risks. Forex risk management is all about identifying these risks in an attempt to minimise them and, in doing so, protect yourself from the downsides of trading as much as possible.
Therefore, we can identify four key stages in any trading risk management strategy:
Identify the risks;
Analyse those risks;
Find solutions to minimise those risks;
Consistently manage and apply those solutions to your trading.
Creating and implementing a sound risk management strategy is crucial if you are hoping to be successful in the Forex market.
The Leverage Effect
Leverage is one of the biggest attractions to trading Forex and CFDs, and it is easy to see why. When used responsibly, leverage is an incredibly useful tool, which allow traders to magnify their potential profit. However, as we noted at the beginning, this magnifying effect also applies to potential losses and, therefore, leverage should always be used with caution.
As an example of how leverage works, if you have a trading account with leverage of 1:100, this means you can open a position worth $10,000 with a margin of just $100. In other words, for every $1 in your trading account, you can access a Forex position of $100.
The higher the leverage you use, the less margin you need in your account to open a position and the faster you will gain profit or lose capital. Traders, particularly beginners, should think carefully about what level of leverage they feel comfortable with before they start trading.
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Inaccurate Market Assessment
Forex and CFD markets are subject to constant price movements. Furthermore, every order traders place start in negative territory due to the spread (the difference between the bid and ask price).
Taking this into consideration, it is little wonder that your market assessment will not always be correct. You will sometimes lose trades and, consequently, capital.
However, how much you lose can be controlled by always setting a stop loss at your maximum acceptable loss for each trade. Nevertheless, bear in mind that setting stop losses too narrowly might lead to your order being closed due to minimal market movement.
Remember, not every trade will result in profit.
Rapid market movements
The market is constantly influenced by news, opinions, trends and political decisions, with prices often reacting within milliseconds. Two examples of potential market-influencing events are:
A central bank announcing a major interest rate decision, which can cause gaps on a price chart within seconds.
A professional market player employs large funds to intentionally cause a significant shift in a particular market.
Even if you are actively paying close attention to the market, it is not possible to know every change before it happens. Therefore, as we mentioned in the previous section, always, set a stop loss to automatically close your trade for you when necessary.
Remember, a stop loss won’t help you completely avoid loss, but it will help minimise it.
Market gaps are significant changes in price that appear on a price chart as gaps in the price. They usually occur when the market is closed, but open markets can also react to unexpected news in such a way that causes trading orders to close far from the desired threshold.
So, why is this important? Because even automated mechanisms, like a stop loss, can only execute orders at the next available quote. This is best illustrated with an example.
The GBP/USD chart below shows an unusually large gap right after the weekend in February 2022. There are no prices inside the gap, meaning that, if there had been a stop loss placed within that gap, it would have been impossible for it to have been triggered before the next available market price.
Source: Admirals MetaTrader 5 – GBPUSD M15 Chart. Date Range: 24 February 2022 – 28 February 2022. Date Captured: 5 August 2022. Please note: past performance is not a reliable indicator of future results.
In Forex trading terms, the illustrated gap in this chart represents negative slippage. But of course, a gap this size could also work in the opposite direction, causing positive slippage, where you earn more profit than your desired take profit would have produced.
Risk Management tools
Stop loss - knowing your limit
Choosing the ‘right’ stop loss is a subject which is discussed in countless articles and reports but, the truth is, there is no golden rule for all traders or all trades. You need to choose an appropriate stop loss for you and your trade. Here are some questions you should consider when making this decision:
What is the trade`s time frame?
What is the target price and when do you expect to reach it?
What is your account size and current balance?
Do you already have any open positions?
Does your order size match your account size, account balance, time frame and the current market situation?
What is the general market sentiment (e.g. volatile, nervous, awaiting other news)?
How long will this market stay open? Is the weekend coming soon or is the market closed overnight?
As there is no general rule for the stop loss limit, we suggest experimenting on a free demo account, in order to find out what works best for you without risking any capital. On a risk-free demo account, you can practise trading and testing various stop loss orders in different places in different scenarios.
In the Forex and CFD markets, price quotes can move rapidly, particularly when there is uncertainty or volatility in the market. An intelligently placed stop loss usually reacts much faster than a human could, making it one of your most important trading risk management tools.
With our Forex and CFD trading accounts, you can easily create a stop loss when opening an order as well as retrospectively add or edit a stop loss for an existing position. Furthermore, with the exclusive MetaTrader Supreme Edition add-on for MetaTrader 4 and MetaTrader 5, clients of Admirals can access the Mini Terminal, providing additional options for setting stop losses.
It is important to understand that some of your trades will result in losses. This is perfectly normal, even the world’s most successful traders do not profit on every single trade.
Therefore, it is important to never overexpose yourself on any one trade, regardless of how confident you think you are of the outcome.
We have already discussed leverage and its potential advantages and disadvantages. The bottom line is that the choosing leverage which is too high for you can considerably increase your risk. This can result in your trading results being ruined by a few negative trades.
Think carefully about the level of leverage with which you feel comfortable before you start trading. As with stop losses, there is no right answer as to what level of leverage is best, as it will depend entirely on the individual trader.
Make sure you choose the level of leverage that is right for you.
Remember to consider external factors in your Forex risk management strategies. There are numerous examples of factors outside of your control that can disrupt your trading, such as:
power outages and/or a failing internet connection
being distracted by work from your day job
Try our trade calculator to experiment with trading scenarios.
Added Value Services
You may already know that Admirals has been providing award winning access to the financial markets to our clients for years, but did you know that we also provide safeguards and Forex risk management tools at no additional cost?
A margin call is an automated trigger to notify you when your account reaches a low margin level, which can help you make timely decisions about whether to close a trade.
Your account balance in MetaTrader 4 or MetaTrader 5 will be highlighted in red when your account reaches a margin level of 100%.
A stop out is an automated trigger to close a trade once you reach the stop out level. This can help protect you from greater losses in open markets by:
Constantly monitoring the margin level and updating it in real-time
Closing all open positions in your Trade.MT4, Zero.MT4, Trade.MT5 or Zero.MT5 account at a specific margin level.
Stop outs do not protect against slippage as they are not immediate and are only triggers to close a position at the nearest available price. Therefore, the price at which the stop out is realised may be different from the price at which the stop out is triggered.
When a stop out is activated, open contracts (or trades) are closed one by one, starting with the trade with the biggest loss. Once the trade is closed, the margin on your account will be recalculated based on any remaining open trades. If your account hits its stop out level again, the next open trade carrying the biggest loss will be closed, and so on.
Managing Risk in Extraordinary Events
On 15 January 2015, the Swiss Central Bank unexpectedly unpegged the Swiss franc from the euro. Panicked trades ensued, causing an enormous surplus on one side of the market, which led to a severe lack of liquidity, making trading near impossible. As there was virtually no liquidity for a while, stop losses experienced large delays that were far off their intended target values. This led to significant rejections and losses as well as negative account balances for countless traders.
This kind of extremely rare event is known as a Black Swan. At Admirals we are dedicated to providing clear, open information that helps you prepare a trading risk management strategy. However, in the case of a Black Swan – there is no chance to prepare! In the case with the Swiss Central Bank, two things were made clear:
Unpredictable events can lead to game-changing alterations
Even central banks can change their mind
Unfortunately, Black Swan events cannot be planned for or calculated. So as a general rule, for successful Forex and CFD trading, never risk more money than you can afford to lose in the worst-case scenario.
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Analyse past results to understand future risk
One way of increasing your chances of avoiding many of the Forex and CFD trading risks we have discussed involves learning from historic trades. Taking time to analyse your completed trades and keeping a trading journal are sensible steps to take.
Analysing your past Forex trades will provide useful insights into risks and personal weaknesses, and will help you learn from your mistakes. For example, you may learn that you:
Are adept at trading around news, or have benefited from a Forex risk management strategy that you should explore further
Have generally negative outcomes from misusing a specific instrument, or recognise shortcomings associated with your current Forex risk management strategy.
The learning possibilities are endless, analysing your past trades can positively influence your future ones. Knowing your strengths and weaknesses is essential to successful trading.
Advanced features in the MetaTrader Supreme Edition plug in such as the Trade Analysis section, can help you analyse your historic trades with a range of extensive information.
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Know the Big Picture
The Forex and CFD markets offer numerous opportunities to profit by going both long and short. But remember, it can also deliver big losses if you do not practice effective trade risk management.
Identifying your weaknesses and managing them correctly can help limit your losses, because even if you were to profit 9 out of 10 times, it only takes one loss to instantly remove all those gains.
We know that the psychological factors around losing trades can be disheartening for beginners, but it is important to understand that losing is part of the overall trading experience. Instead of dwelling on these losses, you should consider what lessons you can learn from them. Before making your first live trade, it is crucial to understand:
Losses are unavoidable
How to psychologically handle losses before they even occur
This article serves as a trading risk management overview by offering explanations together with useful countermeasures for general Forex and CFD trading risks. However, Admirals does not provide investing or financial advice, therefore:
Use this basic information to improve your personal risk management
Be aware that this information will only help you limit your risks – there is no way to completely remove them
Refining suitable trading risk management strategies and consistently exercising them, can significantly improve your profit/loss ratio for successful trading.
Identify possible risks in trading products with leverage.
Develope risk management strategies that fit your trading preferences.
Apply strategies you have developed continuously in your trade management.