Top 8 risk management strategies in forex trading
Did you know the US dollar spiked to a 20-year high in May 2022 after having risen for five straight weeks? This performance of the US dollar was backed by traders looking for risk-averse instruments. While the forex market is highly dynamic, it’s always good to have solid risk management techniques while trading. Here’s a look at some of the simplest ways new traders can manage risk.
#1 – Begin with a demo account
A demo account is a great first step to begin forex trading, as you can experience trading in real-world conditions without the risk of losing any of your money. The purpose of a demo account is to help you get familiar with the forex trading platform and trading tools and to practice trading without any risk before opening a live account. You can also test your forex trading strategies and learn how the forex market works.
Once you’ve got a handle on how your trading platform works, run some technical analysis using the pre-installed indicators and made some demo trades, you are in a much better position to know what to expect under different market scenarios. This can help set you up for more confident trading on your live account.
But even once you are trading on your live account, your demo is still a valuable tool to test your forex trading strategy when trying out a new currency pair or another financial instrument.
#2 – Diversification
Even the most experienced traders use diversification to manage their risks. It’s always wise not to put all your eggs in one basket. Diversification is putting money into different instruments with a negative correlation (responding differently to the same event) or having no correlation (responding to different events).
For example, gold and exotic currencies have exhibited a negative correlation. The news of the Russia-Ukraine war impacted risk appetite, sending exotic currencies lower and gold higher. On the other hand, ZAR (South African Rand) and AED (UAE’s Dirham) do not correlate. If a news event impacts ZAR, it may not impact AED.
#3 – Use stop loss to limit losses
Most new traders plan their entry price for their trade but don’t plan their exit price. Fewer traders plan their exit price in the event prices move against them. Doing so is possibly the most effective risk management tool – the stop loss, especially if you are new to trading.
Stop loss is designed to limit losses on a specific position in the forex or other markets. For example, the EUR/USD is at 0.93, and you expect the US dollar to rise. You decide to buy $100 and set a stop-loss order at 0.92. If the US dollar rises to 0.94, you make a profit of €1. However, if the greenback makes a sharp downturn to 0.90, your stop loss order gets executed at 0.92, and you make a loss of €1. Without the stop loss, you would have lost €3 in seconds.
#4 – Use take profit to book your profits
Apart from stop loss, it is a good idea to set up a take-profit order, which is designed to ensure you book profits before the market moves against you. When the price of a currency pair moves just as you had predicted, it is easy to get tempted and hold the position open to maximise your profits. However, the market can suddenly reverse. This can be prevented by setting up a take-profit order, which ensures your position closes when the forex pair reaches your chosen price.
# 5 – Keep your emotions in check
It is normal to feel anxious when the market is moving against you. Similarly, it is easy to get excited when your prediction comes true. You may feel overconfident after a few wins or experience fear and stress after the currency pair moves contrary to your expectations. These emotions blur you from making the right decision at the right time, significantly since the forex market can move quickly and require you to act quickly.
The best way to keep emotions in check is to have a pre-determined trading strategy. You can use technical indicators to formulate your strategy and test the strategy on your demo account. Once you begin forex trading using the live account, relying on your strategy helps you leave your emotions at the door.
#6 – Have a risk-reward ratio
A forex risk-reward ratio is a way to evaluate these elements comprehensively. For example, if your risk-reward ratio is 1:4, you will enter only those trades in which the potential gain is four times more than the potential loss. For instance, if you open a trade worth ZAR 100, your estimated potential return should be ZAR 400.
Having a forex risk-reward ratio in mind will help you be profitable in the longer run, even if some trades go against you. This is because your successful trades will be worth four times your failed trades.
If you don’t see a potential upside in a forex pair that is worth it, you can move on to another pair. This helps you put your capital to the best possible use.
#7 – Be careful with leverage
Leverage is when you use funds borrowed from the broker to open a position. It helps you gain more exposure than you would have by just using the funds in your trading account. However, it’s important to remember that while leverage can multiply your profit, it can also multiply your losses. One of the main reasons trading derivatives is so attractive for traders is because they can use high leverage on such trades. However, while you are still learning to trade, it is best to use leverage in a calculated way.
#8 – Keep learning
As a trader, your learning never stops. Consider joining a broker that offers free educational content and news and reports on the market. Using these will help you improve your trading strategies.
Risk is a natural part of trading
Where there is an opportunity, there is always a risk. Perhaps the most important rule to trading is never to risk more than you are willing to lose. It is a good idea to keep honing your forex risk management techniques, along with your trading strategies.
Learn the Terms
Risk appetite: This is the amount of risk you are willing to take to pursue opportunities to make a profit. Traders with higher liquid capital (money left over after accounting for expenses, savings and investments) tend to have a higher risk appetite.
Demo account: A free account on which you can begin trading with virtual money instead of real money.
Stop loss order: An order placed below your entry point to limit your losses if the market moves against you.
Take profit order: An order placed above your entry point to book profits when your prediction comes true and before the market suddenly reverses and moves against you.