- Forex traders can manage their risks with tried-and-tested techniques.
- Forex investments face certain risk factors, including volatility, price risk, interest rate changes, liquidity, mishandling of leverage and major political events.
- Risk Management strategy helps traders set comfortable Forex risk limits.
- Traders maintain a profitable risk-reward ratio to minimize losses.
- An investor’s emotional state is a significant factor in risk management.
Professional Forex traders could lose every other bet and still make money. Forex risk management techniques help individuals trade with more certainty and develop long-term strategies. Financial markets always carry a degree of risk and knowing how to navigate the playing field can be the difference between making profits or dealing with losses. You can choose how much risk you’re willing to take in each trade and hedge losing bets with a strong risk management strategy. The beauty of investment trading is that you only have to be right once to pocket substantial profits — even if you lose prior bets. If you continually manage your Forex risks well, your trading account can become a side job or even a serious business.
What is risk management in Forex?
Volatility is like the Grim Reaper for many investors, especially Forex traders who deal with high-leverage, high-volume, and highly-fluctuating currency exchange markets. Effective risk management techniques help Forex traders minimize downsides of losing bets. Viable Forex strategies help traders remain profitable during those disastrous volatility storms — usually following significant political events and major economic announcements. Effective Forex risk management strategies include some of the following factors: emotional trading, risk appetite, risk-to-reward ratio, correct lot positions and stop/loss orders. Every Forex position carries a certain type of risk.
Types of Forex Risk:
- Volatility risk — abrupt fluctuation in currency price can wipe your account out or trigger your stop-loss order even if the position would turn out to be profitable after a period of time.
- Price risk — certain assets are more expensive than others, and trading USD/EUR is not priced in the same as NZD/JPY.
- Interest rate risk — central banks can artificially increase or decrease the value of money by changing the base interest rate (price at which commercial banks borrow money from the central bank).
- Liquidity risk — some assets are not in demand, and selling them could be problematic. Liquidity risk is often a risk associated with exotic pairs, i.e., PLN/JPY.
- Leverage risk — leverage is a double-edged sword that cuts both ways. You can earn 100x more with the right leverage, possibly turning $100 into thousands of dollars. You can also lose that $100 just as fast if you overleverage your position. Rakuten offers leverage up to 400 to 1 on major Forex currency pairs, depending on the trader’s capital and experience.
Top Risk Management Techniques to Protect Forex Investment
Forex winnings are usually counted in pips (minimum units that can be traded). Pips make for the fourth decimal point after a break. If the USD/EUR pair moves from 1.2198 to 1.2195, that’s a three pips difference. Most brokers charge a few pips spread for their services instead of charging high-flat fees for managing your account. Spread fees lower the barrier of entry and help everyday traders participate in the Forex markets. Rakuten offers a tight spread on most pairs, most notably a low spread of 0.5 (half) pips for EUR/USD and AUD/USD pairs. Investors use several risk management techniques to get the most profits with every risk. Here are the most notable factors included in a sound risk management strategy.
Don’t underestimate your leverage
High leverage is a speedway to high earnings or fast losses, and it also makes trading Forex possible for everyday investors. The profits are made and lost at the fourth decimal (pip) of a currency pair, which means high investment capital. With 100:1 leverage, the broker (in association with a bank) offers their clients the ability to invest 100x more than they currently have in the account, reaping 100x more in profit or loss. Meaning, investing $1,000 at 100:1 lets you effectively trade with a balance of $100,000. Traders, brokers, and banks are not at risk of losing the borrowed money because the trading software immediately cuts off any position if the borrowed capital is at risk, and traders don’t end up indebted with the bank and brokers. However, if the software shuts your position, it means your account is empty. Don’t overleverage your position, and start with a position that gives you enough flexibility to maintain a strong account. Sometimes that’s as low as having leverage of 20:1 or less.
Choose a profitable risk to reward ratio
Every investor should aim for high wins and small losses. The conventional advice is to choose a 2:1 risk-reward ratio in everyday trading. Traders can still make money, even if they lose every other bet. Traders have to effectively lose two bets and win only one to break even, which increases the chances of making an overall profit. If the maximum potential loss (risk) is $300 and the maximum potential gain is $600, then the risk-reward ratio is 1:2. You only have to be right 50% of the time to make a profit. However, the 2-to-1 risk management strategy is not the perfect solution for every trader. You can still lose money with a 2-to-1 strategy. Safer options would include digging into more extensive research, finding underestimated pairs, and positioning bets for 3-1 reward. With a 3–1 risk to reward ratio, traders can make a profit even if they’re right only 30% of the time.
Always use stop and limit orders
Forex markets are volatile and could possibly change direction at any second. Forex is collective psychology played out in real-time, and hardly anyone can predict every nuance that affects the largest global financial market. Hedging your bets with stop/loss orders, limit orders, guaranteed stops, and trailing stops protects your account against any uncalculated losses. Professional traders rarely ever open a trade without having two exit factors: wanted loss and estimated risk. Traders choose how much risk they take at any given moment. However, following your decisions turns increasingly difficult with high-intensity trading. Emotional factors come into play, and many traders take heftier risks in the spur of the moment. Staying emotionally neutral is essential for maintaining a viable Forex risk management strategy. Placing a limit order guarantees protection against personal emotions and guarantees a safe exit if the market abruptly turns against you.
Risk management techniques are essential for viable forex trading
Forex markets are lucrative for investors who know how to manage their investment risks. Viable risk management strategy takes lot size, risk-to-reward ratio, and the emotional state of traders into account and executes limit orders for every position.