The Trading Bible Trading Guides Risk Management in Forex Trading Explained
What is Risk Management in Forex Trading?
By Stjepan Kalinic, Updated on: Apr 07 2023.
Forex risk management is a process of identifying, assessing, and controlling the threats that arise from foreign exchange speculation. It helps mitigate and minimize the material and non-material downside of forex trading. While the material downside is a capital loss, non-material downsides like stress and other psychological factors are less discussed.
“Loss“ is a short yet menacing word. Eric Weiner calls it “a Napoleon among the nouns.” This is why we don't experience a loss — we suffer a loss. It comes onto us and leaves us anywhere between concerned and ruined.
Those who don't know where they're going are said to be lost.
On financial markets, during the institutional collapses like with Long Term Capital Management in the 1990s or Archegos Capital in 2021, we can point out the moment when “all was lost. “
Traders don't like losses, yet they are an inevitable part of the game. In this article, we'll discuss the risks of trading forex and how to manage them.
How can forex risk management help traders?
Forex risk management allows you to create rules and guidelines that will minimize the market risk. This risk is inevitable for any trader as long as they are in the trade.
However, some practices can make this risk manageable. It is not only about reducing monetary loss but also mental stress.
The fallacy of survivorship bias
While you might run into traders who claim success without a risk management strategy in place, this is an example of survivorship bias.
Survivorship bias fallacy; Source: XKCD
Survivorship bias is a logical error of focusing on those who made it through the selection process while overlooking those who didn't. In this case, you'd need to consider all the traders who didn't manage their risk and consequentially blew their accounts to find the percentage of those who “survived.“
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What are the main forex risks?
There are many risks that forex traders need to keep on their minds all the time. Unlike individual stocks, forex markets trade around the clock and fall under a much wider influence. Here are some prominent risks to consider when exposing yourself to the currency markets:
- Interest rates: Interest rates are one of the top movers of currency markets. While they don't fluctuate freely (they are set by the central banks), they determine profitability, as a currency with a higher interest rate will be more attractive. However, surprise rate cuts or hikes significantly raise the volatility, often whipsawing the retail traders before the market settles at the new equilibrium.
- Local or regional volatility: Geopolitical turmoils have a significant impact on the currency because currencies facilitate foreign trade, and institutions scramble to adapt to the situation. A recent example is the extreme volatility of the British Pound during the EU referendum in 2016, as it remained unstable long after the referendum – eventually crashing months later. Another notable example is the decision by the Swiss National Bank to remove the peg with the Euro in January 2015. This caused an unprecedented rally and significant turmoil in the currency market.
- Liquidity issues: Liquidity is important for any market as it minimizes the cost of trading. Although the forex market trades 24 hours per day, that doesn't mean instances of low liquidity never occur. Liquidity issues can cause significant increases in spread cutting deep into the profits so traders should be mindful of that.
- Margins and leverage: Forex traders have a love/hate relationship with leverage, as this market has some of the highest available leverages of all the markets. It is not unusual to see an offshore broker offer leverage to a tune of 1:300, or even 1:500. Yet, while it can be tempting to boost the returns during periods of low volatility, it is a double-edged sword as a sudden volatility spike can destroy your account.
Forex risk management methods
Here are some methods of dealing with risk in forex trading:
- Use a stop loss: The first and the most basic way of risk management. Stop-loss placement is a vital part of forex risk management. Often it requires some experience and a keen eye, but when in doubt, you can check the average true range (ATR) and use 10% of it as a minimum stop-loss.
- Place protective hedges: If you must hold the position overnight, or over the weekend — consider placing protective hedges. By using a stop-limit order, you will eliminate the risk of the market temporarily reversing against you. This way, you can step away from the charts without worrying about your stop loss getting triggered on a random price spike.
- Revise take-profit strategy: Nobody ever got broke by taking profits. Since the market changes through the year, periodically review your profit-taking to check if you hold the trades for too short (leaving money on the table) or too long (exposing yourself to additional risks).
- Don't abuse leverage: If you get overleveraged, the possibilities to blow up are growing exponentially. While there are no firm rules regarding leverage, we recommend not using more than 1:10 for beginners and 1:30 for intermediate traders.
- Minimize time in the market: In the forex market, anything can happen at any time. Yet, you can reduce that risk by staying in the trade as short as possible. At times this might result in closing your trades prematurely. For example, if you open the trade on Wednesday and it is Friday afternoon, and you are 10% away from your profit target. You should consider closing the trade to mitigate the risk of holding over the weekend.
- Check the news calendar daily: Regardless of your strategy, you should check the news calendar every day even if you have no positions but are planning to trade. News drive the markets, and trading around them can be perilous. If your strategy doesn't specifically revolve around news, you should avoid trading at least 30 minutes around the high-impact news.
Conclusion
No matter how good the strategy or the trader is, losing money will be an inevitable part of trading. While it is not possible to eliminate it, using risk management techniques allows to keep the losses in check and weather the storm.
These techniques will help a good trader survive any short-term turmoil, knowing that their luck will inevitably turn. For those risk-savvy traders, time is the best ally as it multiplies their wealth. And for the others, it is an adversary.
Frequently Asked Questions
Why do 90 percent of traders fail?
There are many reasons why a majority of traders fail. Most of these come down in 3 categories: strategy, tools, and mindset. While strategy concerns the approach that should fit their personality, tools deal with technical aspects of trading. Yet, in our opinion, mindset is the single most important thing to master, as traders with unrealistic expectations who lack discipline will inevitably fail.
How is risk/reward calculated in forex?
To calculate risk/reward in forex, you have to divide the distance to take profit (minus the spread) with the distance to stop loss. For example, if your take profit is 20 pips, your spread is 2 pips, and your stop-loss is 9 pips, this would give you a risk/reward of 1:2. Meaning you’d have to win only one in 3 trades to break even — everything above that would be profit.