The forex market has no guarantees, and unlike gambling, it is not a guessing game. Therefore, the onus is on you as a trader to understand risk management and apply it because ultimately, it is your money you risk losing.
Understanding how to protect your investment and profits is a crucial aspect of trading that you can learn, and that is why this article will give you the best advice on managing risk in trading.
We will discuss important aspects of risk management:
- Following your trading plan
- Understanding the leverage principles
- Determining your risk to reward ratio
- Using stop-loss orders and managing your emotions
What is risk management?
Traders often overlook risk management, and yet it is the most crucial aspect of trading. People start trading because they want to make money. However, you can also lose money, as we all know.
Essentially what risk management is, is how we manage our potential losses. Ignoring the rules of risk management is simply like betting on an outcome and hoping for the best.
If you plan to use trading as an additional source of income, you need to think of it as your own business. But, of course, there are profits and losses in any business, and you must set goals for yourself as to how to achieve specific targets.
Your trading plan will become a decision-making tool. Together with the trading plan, you can also use a journal to record all your trades and the results. This way, you can review your trading decisions and adopt a disciplined approach.
The trading plan would contain the following information:
- Capital to be invested
- Pairs to be traded
- Lot size to be allocated
- Risk to reward ratio per trade position
- Stop-loss and take profit targets
- Trail profit strategy
You can quickly draw up a trading plan in a spreadsheet or a notebook, depending on how sophisticated you want it to be.
Leverage is borrowed from the broker to increase your trading position. It allows you to trade with a small investment but enables you to maximize potential profits. For example, traders use leverage to profit from small changes in the price of currency pairs, but it can also inflate the losses should a trade go badly.
For example, if your broker’s margin is 1%, you trade a standard lot of USD/CHF. One familiar lot would be $100,000. The margin needed is 1% of $100,000 which is $1000. Applying the above formula, the leverage required for this position is 100:1 (100,000/1,000).
You can choose how much leverage you would like to use but keep in mind that the more leverage you choose, the more risk you are taking. For example, if your trades go in the opposite direction and do not have enough margin to cover your losses, you could risk losing your investment.
You, therefore, have to understand how much you risk losing when choosing the amount of leverage on your account.
Risk to reward ratio (RRR)
The risk to reward ratio is the potential reward you can earn for every dollar that you risk in a trade. Traders use risk to reward ratios to determine their expected profits compared to the risk they will take.
For example, a trade position with a risk-reward ratio of 1:5 means that for every dollar you risk, you potentially could make $5. Another way to look at it, if your potential loss on a trade is $200 and the maximum profit is $600, it means you have a RRR of 1:3.
By setting an excellent risk to reward ratio, you want your profit to outweigh your losses so that you can make money in the long term. Of course, you will most likely lose on individual trades, but you would want to be in profit over a long period.
Stop loss/take profit/trail stops
Due to the FX’s high volatility, you must know when to enter and exit trades.
Trades will not always go according to your analysis, and to manage your losses, you have to set stop limits to protect your investment.
Once you have determined your risk to reward, you can choose where to place your stop-loss price. Then, if the market moves against you, it will automatically trigger your stop loss and close your position. This way, you protect your capital with minimal risk.
Take profit targets are set based on your risk to reward as well. You have to enter the price at which you want your position to close once in profit. The market will trigger your take profit price and close your trade position.
Using a trailing stop is a clever way of securing your trade once it is in good profit. A trailing stop is a price set a certain number of pips behind the market price.
If your trade is in profit and the market reverses in the opposite direction, you will use the trailing stop to protect your profit. If the market reached your trail stop price, it would close your position still in some profit.
Managing your emotions
Greed, anxiety, and excitement can influence your emotional maturity during trading. However, you are putting your investment at risk by giving in to your emotions because your decisions are based on your feelings and are not factual or calculated.
Once you allow your emotions to drive your decision-making process, you are not managing your risk. Instead, emotional trading clouds your judgment, and you are unable to make informed decisions. However, you can apply methods to manage your emotions, some of which we have mentioned in this article.
Other tips you can follow to control your emotions:
- Once you feel overwhelmed by emotions, take a break and step away from your trades.
- Learn to accept your losses and move on, do not take counter trades to recover losses.
- Follow your trading plan.
- Learn to train your emotions, practice patience and discipline
- Once you make your targets, stop, and do not trade out of greed.
The five aspects we reviewed are sufficient to help you manage your risk and make money in the long run. If you apply these rules to your daily trading routine, you will adopt some good habits, which will help you manage your emotions.
The nature of the forex market is a high risk, and only by applying steadfast rules can you aim to achieve your goals. Ultimately, trading is to make money and not lose it, so it is imperative to any serious trader to learn how to protect your investment by managing your risks.