The forex market presents a range of opportunities for traders to earn significant profit due to the presence of volatility. However, this also comes with its own set of risks that one should manage.
As an individual trader, you need to understand the concept of risk management in forex before you actually start trading. In speculation it refers to a set of measures that you can implement to manage the negative impact of losses. You should conduct proper planning from the start to ensure that you have an effective strategy with a good risk management system in place.
What Types of Risk do You Face in Forex
Risk management is a major ingredient in ensuring success for experienced as well as novice traders. However, before you go about managing that risk, you must have full knowledge about the different types of forex risks that exist in the market.
Liquidity risk: There are some currencies that have more liquidity than others. This usually means that the demand and supply for that currency are high and trades are executed fast. Other currencies where there is less demand can cause a delay when you open and close a trade in a trading platform. This may result in the trade not being executed at the correct moment, resulting in a significantly smaller profit.
Leverage risk: As a trader, you can use leverage for opening trades which are much bigger than your deposit. However, this also means that you can lose more money than your initial deposit in some cases. Thus leverage acts like a “double-edged sword”.
Market risk: Financial markets won’t always perform as you expect. As a trader, you should be ready for any kind of risk during trading. This is where technical analysis and gathering extensive knowledge about the market come in handy.
Risk of interest rates: Interest rates for currencies can suddenly rise or fall which affects their volatility. This is due to the level of spending and investment being different in each economy.
Five Vital Forex Risk Management Tips
There are certain strategies one could take to efficiently manage risk in forex trading.
Learn About the Forex Market
The forex market consists of currencies from around the world and is ideally driven by forces of supply and demand. Each currency is correlated differently with one another and the market is influenced heavily by geopolitical news. If you’re a novice trader, you should dive in deep into the nuances of the market with the help of the educational videos and material found online. This is necessary before entering the market for active trading. Luckily most online forex brokers provide educational resources for novice traders, in the form of webinars, videos, and blog posts.
Set A Risk-Reward Ratio to Follow
As a trader, you would ideally want your profit to dwarf your losses an aim for the long run. This means there will be times when you’ll lose on individual trades. To quantify your trades, you should therefore set a risk-reward ratio. To this, simply compare the amount you are risking per trade with the potential profit of that trade. For instance, if the potential profit of trade is $300 and the risk (potential loss) is $100, the ratio is 1:3.
Understand the Implications Of Leverage
When trading in the forex market, there are high chances that you will be trading on leverage. Leverage helps you to get access to a bigger instrument with a small initial deposit called margin. Trading with leverage has both upsides and downsides. If you’re a novice trader, you should avoid trading with leverage until you have a clear idea of the potential losses than you can incur.
Develop A Concrete Trading Plan
Starting to actively trade in the market without having a trading plan outlined is one of the worst mistakes ever. Thus, to properly manage forex risk, you should have a trading plan in place. A typical trading plan should consist of when you’ll open or close a trade, your minimum risk-reward ratio, and the percentage of risk you’re willing to take, among other things.
Following a trading plan strictly will help keep your emotions out of the way, preventing you from over-trading. Your entry and exit strategies will be clearly defined in your trading plan. This way you’ll know when to cut your losses or to take your gains without second guessing. This discipline is crucial for forex risk management.
Use Forex Correlations
Forex correlation shows how changes within one currency can influence changes within another currency pair. For example, AUD/JPY and EUR/USD are correlated and have a common trend. This means that a negative trend in one pair will also mean that there is a negative trend in the other. Margin mainly drives risk in the forex market and you should avoid pairs that do not have a strong positive or negative correlation with each other.
For beginner traders, the best advice is to start off conservatively. You should practice new strategies in a risk-free environment such as demo accounts, or back-test your strategies before you actually apply them risking your own money. Developing your own effective risk management strategy will allow you to have better control over your profits and losses in the forex market.