What is Risk Management in Forex Trading?

Updated May 08 2022

Risk Management in Forex Trading Explained

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.

Risk Management in Forex Illustration

“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 by XKCD

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:

  1. 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.
  2. 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.
  3. 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.
  4. 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:

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.

Author

Stjepan Kalinic

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