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How to manage risk in Forex trading

Jul 19 2017
Jonathan Smith

We would like to present you with some of the basic risk management knowledge every forex trader should have. Although this article is designed for newer traders, experienced ones may also want to check-up on some of the concepts.


Why it matters

First and foremost, we must highlight why this is extremely important. No matter what your trading strategy is, it is bound to run in a series of losing trades. If you do not control your exposure during them, you may end up with serious losses. And here is the principle which some beginners may not understand: The first step towards making money in the forex market, is to stop losing.

This may sound logical and even obvious, but there is a hidden meaning behind the simplified statement. Whenever you lose money, your total account balance goes down, which implies you would have to trade with smaller lot sizes. This way you would need to gain a lot more, just to return to its previous state. Here is an example:

Scenario A: You have a $10,000 account and you earn 10%, for a period of time. You now have $11,000.

Scenario B: You have a $10,000 account and you lose 10%. Now you are left with $9,000. Let’s say you later gain 10%. You are now left with only $9,900, which is less than the initial amount.

The difference in this simple example is rather small, but think how much you would have to make in order to recover from a 50% drawdown? That’s right you would have to double your account, just to get to the place where you started.

Risk per trade

There are many ways of looking at risk management, but most traders approach it from this perspective: you should only risk a small portion of your current account balance per trade. The important factor is looking at your current account balance and not to keep on using the same position size, you implied with your initial balance. The difference will not be crucial after a streak of 5-10 losing trades, but if serious losses occur, it would be wise to follow this rule.

Most authors recommend a maximum of 2% risk per trade. While this may seem like a small level to some, it is actually rather high. A ten trade losing streak, which is not that unlikely, will leave you with around 80% (81.7 if you follow the previously mentioned rule) of the funds. Much more conservative guidelines are around 1% or even 0.5%.

A practical example

Here is a simple way to manage risk, by determining your position size. You start by looking at your trading set-up. It should require a pre-determined stop-loss level. This is a key factor, knowing your stop in advance and not determining it after doing calculations, based on your account. If you do so, you are essentially trying to fit the market to your wallet, which doesn’t work.

The value of a pip is the next crucial variable. The quoted currency (the second one in the pair) is the one in which profits and losses are measured. For instance, in EUR/USD the market moves are directly calculated in USD. Finding the value of a pip is easy, you have to simply multiply your trading size by 0.0001 (a pip). If you trade with a 4000 unit nominal exposition, or 0.04 in MetaTrader 4, a pip will be worth $0.4 (4000 x 0.0001). The situation is a little more complicated with cross-pars, like AUD/JPY for instance, as you would have to convert the result to your account’s currency.. The last variable you need is your account size, which you obviously know. Let’s put it all together:

You want to trade EUR/USD, with a 100 pips stop-loss and you have a 10,000 USD account. Two percent of a 10,000 USD account are $200. This means you would be risking $2 per pip, which suggests a 20,000 unit nominal position (or 0.20 lots) as the maximum you should risk. Again, this is the maximum, you could easily take a smaller trade.

This is the logic you should follow, star with your set-up, followed by your account size and then determine your size. Trying to work things out differently, by starting with your balance and the size you “want to” trade, will mean you have to place the stop order on a level, which doesn’t follow the logic of your strategy.

Smaller traders may come to a dilemma. After doing these calculations they will come up with a position size smaller than the minimum of 1000 currency units. One of the solutions to this dilemma is opening a cent account with a broker, which provides them, such as FXTM.

Risk per day/week

Another way to look at the risk, which does not contradict the risk per trade methodology is setting a limit on the maximum amount you lose per period of time. This means if you were to lose a certain portion of your account, you would stop trading for the rest of the week/month. Most often a 5% to 10% limit is implied by traders, depending on their preference. This will obviously have to be in-line with the risk per trade. For instance, if you trade with 2% per trade, placing a 5% limit per week may be a bit too tight.

It is also worth determining a level at which you would stop and reevaluate your entire performance. For most traders this is 20% of their balance. If you go down by so much, maybe you are doing something wrong, or these market conditions do not favor your strategy. Serious considerations are required at this point.

A few extra tips

Risk management is one of the most crucial factors when trading forex. The techniques presented here are the most basic approach to the topic, so here are a few extra tips:

Never re-adjust your initial stop-loss. This action would basically render it meaningless. Although doing it once may have allowed you to turn a losing trade into a winner, once you make a habit out of this, you are no longer trading, you are gambling.

Consider splitting your position in portions and then closing some of them earlier than expected, if the market goes in your favor. This can be done by moving your stop-loss order in the profit.

Take caution when trading in correlated markets. If you have positions in EUR/USD, GBP/USD and AUD/USD, you have too much exposure to the US dollar. If its value was to change drastically this will likely impact all three of your positions.

Close the trading platform when you feel angry. No matter how many how stringent your risk management is most of the time, a few minutes of tilt can ruin months of hard work. Whenever you feel like you “need to recover the recent loss quickly”, you are in for a rough ride.

TAGS: forex  risk  management  risk management   
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