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:

• Read this entire guide to learn more about Forex and CFD risk management
• Practise trading on a risk-free demo account
• Explore the Education section of our website, to learn as much about trading as you can

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 a tool used in trading that allows investors to control a larger position in a financial market with a smaller amount of capital. It involves borrowing funds to amplify potential returns.

For example, with a leverage of 1:30, a trader can control a position worth $30,000 with just $1,000 of their own capital. While leverage can magnify profits, it also increases the potential for losses, as losses are also amplified.

Leverage is commonly used in trading forex, CFDs, and futures contracts, but it`s important for traders to understand its risks and use it responsibly.

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

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: Admiral Markets 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.

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.

Order size

It is important to understand that some of your trades will result in losses. This may happen as sometimes markets move against your plans.

Therefore, it is important to never overexpose yourself on any one trade, regardless of how confident you think you are of the outcome.

Choosing Leverage

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.

Please note that there are predefined leverage levels; traders cannot choose randomly the level of leverage.

Make sure you choose the level of leverage that is right for you.

External factors

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
• limited availability due to daily routine tasks

Added Value Services

You may already know that Admiral Markets 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?

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, Admiral Markets 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.