Top Forex risk management strategies and rules to learn

What is Forex risk management?

Forex risk management comprises all the trading tools and techniques that a trader uses to maximize trading profits and minimize trading losses. A comprehensive risk management plan covers every aspect of trading – how you enter and exit trades, using leverage, and position sizing.

Practicing good risk management in Forex trading is what distinguishes successful speculators from mere gamblers. The fact that even a novice trader can enter the Forex market and – thanks largely to the high amount of trading leverage available – realize a large profit in just a matter of seconds, unfortunately, leads many Forex traders to act like gamblers placing random bets at a roulette wheel. They enter trades without a good strategic reason to do so, risk far too much money, and have no idea of when they should close a trade and take profits.

Types of Forex trading risk

Most novice Forex traders aren’t even aware of all the different types of risk that successful traders have to consider. It’s dangerous to be in a market position, unaware that you’re surrounded by potential risks.

Let’s take a look at the different types of Forex risk that traders need to consider.

Market risk

Market risk is the most basic trading risk – the risk that a currency pair’s price movement won’t be what your analysis projects and what’s necessary for your trade to be profitable. Sometimes, you’re just flat out wrong about the market’s most probable future price action. Therefore, you should never enter a trade without considering, “What if I’m wrong?”, and how to best contain your risk exposure.

Interest rate risk

The prevailing interest rates in a country are a primary determining factor in the value of the country’s currency relative to other currencies. Absent other, strong contrary factors, the currency of a nation offering 5% interest on deposit accounts will rise in value relative to the currency of a nation only offering 3% interest. A major interest rate change can affect a trade.

Political risk

Because the Forex market is an international market and one that has a substantial impact on international trade, Forex trading is also subject to political risks. First, political uncertainty or instability in a country usually has a negative impact on its currency’s value. Second, sometimes a country will intentionally devalue its currency in order to improve its import/export balance of trade.

Liquidity risk

Liquidity risk refers to the risk that a trader won’t be able to easily exit a trading position in the event that the market turns against him. If the market isn’t sufficiently liquid, then a trader may have to sacrifice a large part of open profit in a trade in order to exit the trade before it turns into a loss. Worse yet, he may not be able to exit his trade before it suffers a substantial loss.

Generally speaking, the Forex market is the most liquid trading market in the world. However, that doesn’t mean that it has no liquidity risk at all. Sudden unexpected economic events can cause a lack of liquidity in a currency pair. Even in normal trading conditions, some currency pairs are much less liquid than others. For example, the US dollar versus the South African rand carries only a small fraction of the liquidity that exists in trading EUR/USD or GBP/USD.

There are also times of day when the market is much less liquid - typically between the New York close and the Tokyo open.

Leverage risk

Many Forex traders use high amounts of leverage, holding trading positions whose value is, in fact, much greater than the total amount of trading capital in their trading account. We’ll discuss the risk posed by the two-edged sword of leverage in a separate section of this article.

Risk of ruin

The “risk of ruin” refers to the all too common occurrence in Forex trading of a trader losing all of the money in their trading account. The simple fact is that most Forex traders, especially beginning traders with little experience, are much too optimistic about their prospects for trading success. They fail to factor in, and plan for, the very real possibility of, for example, having 10 or more losing trades in a row.

Many veteran traders will tell you that all you really need to do to be a successful Forex trader is not run out of money to trade with. Unfortunately, the sad story of many traders is that of watching a golden trading opportunity pass them by, simply because they didn’t have any trading capital left.

Best Forex risk management strategies and rules

How can a Forex trader smartly manage all the risks inherent in Forex trading? – The answer is pretty simple: Always practice firm risk management strategies as part of your overall Forex trading strategy. A comprehensive set of risk management trading rules will include all of the following elements:

Get a good Forex trading education

Before you ever enter your first Forex trade, you should first educate yourself on the Forex market and the primary forces that drive its price action. There are plenty of free Forex trader educational resources available online. One of the best is BabyPips.com. Also, the Top Forex brokers usually have extensive libraries of educational resources, freely available to their clients.

Trade with a clear trading strategy

Don’t go buying GBP/USD just because you kind of think it might go up, or because you’d like it to go up. You can significantly lower your trading risk if all of your trading moves are guided by a clear trading strategy that has firm rules for both entering and exiting trades. Knowing precisely when, or at what price level, you will close out a trade – whether taking profits or cutting losses – will help keep you from making one of the cardinal trading mistakes, that of making trading decisions based on emotions such as fear or greed, rather than on rational reason.

There are an infinite number of trading strategies to choose from – both technical and fundamental. Find one that has clear entry and exit rules, and that matches your risk tolerance and personal trading style.

Trade with a favorable risk/reward ratio

An excellent rule of thumb in Forex trading is to never enter a trade that doesn’t offer a favorable risk/reward ratio – at least 2:1. That is, don’t enter a trading position unless the potential profit you realistically envision is at least twice the amount of money that you risk by putting on the trade.

Always use stop-loss orders to limit your risk

A stop-loss order is a pending conditional order to close a trade if market price action moves against your trading position to a specified price level. For example, you might enter a buy trade in EUR/USD at 1.1250 and place a stop-loss sell order at 1.1225. If the price of EUR/USD declines to 1.1225 or less, then your stop-loss order will automatically be triggered and your trade closed out.

You can use stop-loss orders to help limit the size of losses when a trade doesn’t work out. You can also use them to help protect profits in an open trade. Assume you buy EUR/USD at 1.1250. The market subsequently moved up to 1.1330. You might place a protective stop-loss order at 1.1290, thus locking in half of your existing open profit of 80 pips.

Be aware that stop-loss orders don’t provide perfect protection. Some events may cause the trading price of currency pairs to suddenly gap up or down by a wide margin. In that event, your stop-loss order may be triggered, but filled at a significantly less favorable price.

Never trade with money you can’t afford to lose

The old saying is “don’t bet the rent money”. You should never invest in Forex or any other financial market with money that you can’t afford to lose – that would affect your ability to cover your regular living expenses. Only and always trade with “extra” money that you have set aside specifically for investing – and that, even if you lost it all, wouldn’t impact your standard of living. If the amount of money you’re risking in a trade is interfering with your ability to sleep peacefully at night, then you’re risking too much money.

Be aware of correlations

Currency pairs that are highly correlated tend to move in the same direction and, often, at approximately the same rate. For example, the currency pairs EUR/USD and GBP/USD nearly always move more or less in tandem. Therefore, if you initiate a long position in both pairs, then you’re essentially just adopting the same trade position – a position against USD – twice.

You should also be wary of trading two currency pairs that have a high negative correlation – that tend to always move in opposite directions. For example, if you buy both GBP/USD and USD/CHF, making one trade largely against USD and one trade largely for USD, then you’re basically holding two market positions that pretty much cancel each other.

It's also good practice to be mindful of correlations with financial assets outside of the Forex market. The relative value of the Australian dollar usually has a positive correlation with the price of gold. Therefore, if your market analysis projects a decline in gold prices, you might well consider reducing any risk exposure you have in AUD currency pairs.

Pay attention to position sizing

You can keep your overall trading risk at a low, acceptable level by making sure that you only trade position sizes that match up well with your total amount of trading capital. Many professional traders recommend risking no more than 2-3% of your total trading capital on any single trade. That gives you a wide berth to make it safely through a long string of consecutive losses and still have plenty of trading capital left – since it would take approximately 50 losing trades in a row to completely wipe out your account.

So, if you only have $500 of trading capital to work with, then you should be trading with a stop-loss that will close your trade with a loss of no more than $10-$15. That may mean having to trade micro-lots for a while until you have increased your trading capital, but paying attention to position sizes will go far to help you avoid the risk of ruin.

Consider using the 5-3-1 Rule

Many Forex traders fail because their attention is too scattered. They’re simultaneously trying to watch the price action in every currency pair, entering different trades based on half a dozen different trading strategies, and letting the 24/7 operation of the Forex market lure them into overtrading.

The 5-3-1 Rule provides an easy solution that replaces all of those bad trading practices with good trading practices.

Here’s the 5-3-1 Rule:

Understanding Forex leverage

The high amounts of leverage available in Forex trading constitute one of its major attractions, because it means that traders can start with only a small amount of investment capital and still generate significant profits.

Leverage, or margin trading, refers to borrowing money from your broker so that you can trade larger positions. With, for example, 100:1 leverage, you can control $100,000 worth of a given currency pair with a margin deposit of only $1,000.

Here’s what’s essential to keep in mind: Trading with leverage will amplify losses just as quickly and easily as it amplifies profits. To help limit your risk, you need to be aware of the amount of leverage that you’re using, and what it translates into in terms of money risked. For example, if you’re trading mini-lots, using 100:1 leverage:

Being aware of leverage risk relates to the Forex risk management rules about position sizing, using stop-loss orders, and trading with a favorable risk/reward ratio.

The leverage available in Forex trading goes as high as 1000:1 with some brokers, but successful professional traders recommend using much less leverage than that. The wisdom of doing so was illustrated by a study done by a market analyst that found that traders who customarily used only 5:1 leverage were profitable more than four times as often as traders using leverage of over 25:1.

Best Forex brokers

1

9.4/10

Go to broker

eToro is a multi-asset investment platform. The value of your investments may go up or down. Your capital is at risk. Don’t invest unless you’re prepared to lose all the money you invest.

Minimum deposit:

$50, $100 (for UK clients)

Bonus for deposit:

0%

Regulation:

CySEC, FCA, ASIC

Review

The eToro broker was founded in 2007. The company promotes itself as a social trading platform working with traders from over 140 countries. The broker has several divisions operating under different jurisdictions and licensed by different regulators. For example, eToro (Europe) is licensed by the Cypriot regulator CySEC (109/10) and eToro (UK) is licensed by the British regulator FCA (583263). The broker also has a representative office in Australia and the USA. eToro Profile Details

Pros/Cons

•the minimum transaction amount for copying is $1;

•handy functionality for passive investing;

•regulated by independent monitors;

•it is possible to purchase contracts for fractional shares (that is, to invest amounts less than the cost of one share);

•it is possible to buy shares at once (not CFDs) on the US stock exchanges.

•high spreads;

•periodic technical failures in order execution;

•lack of the most popular platforms such as MetaTrader 4 and MetaTrader 5 in Europe and the CIS;

•no access to ECN systems, orders are processed only according to the STP (straight-through processing) scheme with access to specific liquidity providers;

•there is a commission for withdrawing funds;

•impolite support staff;

•inconvenient website.

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2

9.2/10

Go to broker

Your capital is at risk.

Minimum deposit:

No minimum

Bonus for deposit:

0%

Regulation:

FSC (BVI), ASIC, IIROC, FCA, CFTC, NFA

Review

The name OANDA is an acronym for “Olsen & Associates” or “Olsen AND Associates”. It is registered in the United States and provides its clients with a wide range of financial services in most countries of the world. The company was founded in 1996 and is currently regulated in four jurisdictions. The main regulator of the broker is the UK Financial Conduct Authority (FCA). Oanda Canada is licensed by IIROC. The company has several significant awards to its credit, including a victory in the category "Best Forex Trading Technologies" from the UK Forex Awards, "Best Trading Platform" from FX Week, as well as "Best Customer Service" from the US Foreign Exchange Report.

Pros/Cons

•Minimum deposit from 1 dollar.

•A large selection of the most popular trading instruments.

•Several reliable and reputable financial regulators.

•Inconvenient and poorly functioning site.

•Lack of cent accounts.

•Lack of bonus programs.

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