Table of contents:
- How to manage risk as a forex trader
- How does risk management apply to the forex market?
- Other risks involved in forex trading
- What is risk management in finance?
- Beware of the odds
- Understand how the FX market works
- Build a solid trading plan
- Define your risk-reward ratio
- Set your exit & limit orders
- Leave your emotions out
- Stay up to date with market news & events Practise on a demo account
It is a well-known fact that trading involves exchanging goods or services between two or even more people. Taking an everyday example, let’s assume that Person X fixes Person Y’s car in exchange for something that X has, let’s say oranges. This type of trading is easy to manage and has a relatively easy management of risk. To reduce the risk involved, X may ask Y to show him/her the oranges before fixing the car. This is what the practical human process of trading looks like.
Nowadays however, with all this technological advancement, risk is uncontrollable especially due to ultra-fast transactions taking place every day. Quite often, traders may fall into the trap of generating revenue as fast as possible and tend to approach forex trading as gambling instead of a business that demands proper research and structured thought. In fact, what distinguishes trading from gambling is managing risk. When speculating on an asset’s price, traders have some control over their trades, which they don’t have with gambling.
All in all, trading within the forex market offers a wide variety of opportunities for profit. However, this also comes with potential risk of losses. Read on to learn about the risks involved in forex trading and how to manage them.
How does risk management apply to the forex market?
As commonly known, the foreign exchange market is influenced by various external factors including economic stability, world events, interest rates, political news, natural disasters and more. Therefore, it can easily become volatile, meaning that there can be changes in a currency’s value. This is a double-edged sword though, as there is the potential to generate revenue while speculating on prices but, there is always great risk as prices can move in the opposite direction. As a result, managing risk as a trader is vital when building your trading strategy.
Liquidity on the other hand, refers to how active the market is. The forex market has $6.6 daily trading volume so when traders get into online trading, there is always someone willing to buy or sell and transactions run smoothly. This is usually the case with major currencies. However, it is not the same with all currency pairs and not all brokers have sufficient liquidity. This is important as most traders usually rely on forex brokers to execute the trade. Nevertheless, major online brokerages are usually fine in terms of sufficient liquidity.
Other risks involved in forex trading
To start with, there is risk around interest rate, as mentioned above, and it refers to interest rate suddenly increasing or decreasing which directly affects volatility in the FX market. Based on where the rate change will move, the spending and investment level of an economy will either increase or decrease. Therefore, changes in interest rate equal impact on forex prices.
Moreover, there is also risk regarding leverage, which basically concerns trading on margin. In such cases, the initial deposit amount in a trading account, is smaller than the actual forex trade. Remember that although leverage may magnify profits it may also magnify losses.
Furthermore, there is liquidity risk which is the risk traders take when they cannot make an exchange fast enough to avoid losses. Although the foreign exchange market is extremely liquid as already mentioned, there are times of illiquidity, which depends on the policies of currencies and government regarding a forex exchange.
Finally, there is risk around currencies, which refers to how prices of currencies fluctuate, resulting in forex assets being relatively costly to buy.
What is risk management in finance?
Risk management refers to spotting, analysing, accepting and possibly reducing uncertainty around trading and investment decisions. In other words, risk management in forex is needed when traders and investors attempt to calculate the potential losses in a trade, after analysis, and act upon this by taking certain actions based on their risk tolerance, objectives and possible trading plan.
Returns and risks are interconnected as every trade comes with some degree of risk. Traders can actually calculate risk. Especially if they fully understand the meaning of it and its various forms, they can enhance their trading approach and evaluate investment opportunities in a more efficient way. So, managing risk as an investor is of high importance.
In practice, forex risk management allows traders to apply a set of rules and actions to make sure that they can manage any possible negative scenario in a forex trade. In order for such a plan to be effective, there needs to be proper planning and research before you start trading.
Beware of the odds
One of the main rules in risk management is calculating the odds of a potentially successful trade. In this case, both technical and fundamental analysis will be needed as well as understanding what drives the market you are trading in. Once you decide to enter a trade, the next step is to determine how to manage risk. Remember that if you can calculate risk, you can probably control it as well.
In order to manage your risks, you need to put everything down right from the beginning, starting from entering the trade to your cut-out point, which is when an investor decides whether or not to buy an asset. The potential risk is found between the two points. It is vital that you accept the risk involved before even opening a position. So, if you are psychologically okay with facing potential losses, then you can take your trading one step further. If you do not feel confident enough, then do not take the trade or else you won’t be able to objectively handle any difficult situation.
Understand how the FX market works
The forex market consists of currencies from all around the globe including the USD, EUR, GBP, AUD, JPY, CHF and more. Also, supply and demand are the determinant factors that drive the market. Similar to any other exchange, forex trading has to do with buying a financial instrument with a currency based on the price determined by the market, which will tell you how much of one currency is needed to buy another currency.
What is more, the first currency in a currency quote is referred to as base currency while the second is also known as quote currency. The price on the charts always refers to the second currency and shows how much of the quote currency is needed to buy a unit of the base currency. Taking the GBP/USD as an example, should the exchange rate be 1.25000, this means that $1.25 is needed to purchase 1 pound.
Traders speculating on the movements of forex prices with CFDs, trade with leverage, meaning that they get full exposure to the market with a rather small initial deposit amount. This is also known as margin. Trading with leverage has both advantages and disadvantages in that it can boost returns, but it might as well magnify losses.
Build a solid trading plan
Building a trading plan will be your guidance throughout your whole trading journey. It can certainly enhance your trading as it will greatly help you in important decision-making. It can also be a very useful tool when having to deal with volatility in the market. Your plan will be there to give answers to any question that may arise while trading including when to enter/exit a trade and why.
This trading plan should be built based on your personal style and goals. Copying others will not help as there will be different objectives hence approaches. Most importantly, there will be a different budget and time allocated to trading. A trading diary can also be helpful so as to keep track of everything you do while trading.
Define your risk-reward ratio
We have already mentioned above that every trade comes with risk, so it should at least be worthwhile. The ideal scenario for traders is for their profits to outweigh their losses. This is a longer-term goal of generating revenue in the long run although you might lose some trades. Setting your risk-reward ratio to measure your trade’s value should therefore also be part of your trading plan.
To calculate the ratio, you should compare the amount you put at risk regarding a forex trade, with the possible profit. For example, let’s say you have a trade that its maximum potential risk is 200 pounds while its maximum potential profit is 600 pounds. The risk-reward ratio is 1:3. Therefore, if you opened 10 trades based on this ratio and just 3 of them were successful your profit would be 400 pounds.
Set your exit & limit orders
Because of volatility in the forex market, setting and deciding on your entry and exit points regarding a trade before even opening a position, is also of high importance. To do that you can use various limits and stops like normal stops, to start with. These will automatically close your position should the market moves against you. However, the risk of slippage still exists. There are also guaranteed stops that eliminate the slippage risk by closing out at the specified price precisely.
Limit orders will move together with your profit target and will exit the position once the price reaches the chosen level. Last but not least, there are trailing stops that keep track of price movements that move in your favour and exit the position should the market moves against you.
Leave your emotions out
Anything that affects the market in a negative way, like volatility in the foreign exchange market, can impact traders’ emotions as well. However, keep in mind that only you can influence your trade’s success. If you are afraid, greedy, have doubts or anything like that, then you may be tempted to trade without a clear judgment. In any case, you should not allow your emotions to get in the way of your trading as they may affect your trading decisions and harm your trades.
Stay up to date with market news & events
As the market continuously changes, it is hard to predict where the prices will move because there are numerous factors, both internal and external that lead to price fluctuations in the market. Make sure you don’t stay behind by keeping track of major events such as important decisions of banks or announcements, news regarding politics and generally market sentiment.
Practise on a demo account
Demo accounts are offered by online brokers to help traders practise their trading strategies before implementing them in real trading. Their goal is to create a risk-free environment that is very similar to the real trading experience so as to get a glimpse of how the market works without losing any funds. This is the main difference between a demo and a live account. If you apply any of the above techniques and build an effective risk management strategy, you will be able to better manage your profits and losses. Forex brokers also offer a broad variety of educational material and tools to help you make informed trading decisions.
This information is not considered as investment advice or an investment recommendation, but instead a marketing communication. FXCess is not responsible for any data or information provided by third parties referenced, or hyperlinked, in this communication