Risk management is among the most underestimated aspects of any business, especially within financial trading. This is a huge factor why businesses go bust or in Forex trading terms – why traders lose money or even worse, blow up their accounts.
Every business carries risks. Whether it’s a supermarket, electricity shop etc. Wherever money is involved there is a risk. If you don’t anticipate and manage the down side, you are destined for failure. Only by understanding the risks can you find a reward and a success.
In this article we are going to cover the most important aspects of risk management and detail how to manage them.
As mentioned above, any new business endeavour carries some risk. Forex trading isn’t different. Before you invest your hard-earned money, you have to value the risks. Fortunately for the retail traders, when starting out with forex trading, this risk could be minimized to literally 0. How? By using the demo accounts. Demo accounts are a great creation by brokers. This is where you trade with virtual money in conditions that replicate the real markets.
That’s why starting out with a demo account is a great idea. You can test, learn, experiment with no risk. However, once you get familiar with the basics, it’s smart to move on and trade real money.
As good as a demo can be, nothing can compare to the emotions, the excitement and the chance of high profitability of the real trading. At the end of the day, you want to be a trader that makes money, not just a trader that draws nice lines, right?
And that leads us to the next subject.
When you believe you are ready to continue to live trading, a very important question comes to mind. How much money should I start with? Here is a VERY important tip – the initial capital that you are going to invest should be money that you can allow yourself to lose.
Bottom line – never forget that trading forex for a living is a real business. As mentioned above, any business carries some risk. You may not lose all of your capital if you follow some basic rules, but always consider the possibility of losing. In other words, always invest money you can afford to lose.
Self-awareness and a general understanding of reality are critical before you start your live trading.
Younger traders (in terms of age) tend to tolerate higher risk, be less patient and in general, are attracted to quicker gains. This ultimately leads to shorter-term trading. It is a common belief, even among advanced traders, that taking more trades automatically leads to more profits. Reality proves that successful traders are often the patient ones.
Goals and expectations can also ruin you as a trader. It is vital to have realistic goals and expectations, especially in the beginning of your career. Numbers like 50% a month, 100% a month should not be on your agenda. The very first thing you MUST learn as a trader, is how to protect your capital and not lose, profits will follow accordingly.
Emotions and Risk Limits
It is advisable to include in your trading plan a Risk Profile. Many traders make the mistake of entering a trade without understanding how much they risk, and how much they expect in return. They just trade because they believe something will move up or down, or even worse, because someone else said it will…
Here is a simple example of how your risk profile might look:
- Risk per trade – 0.5%
- Risk per day – 2%
- Risk per week – 3%
- Risk per month – 5%
(Sample numbers only – it’s not a recommendation for action)
This kind of risk profiling is effective for multiple reasons. First of all, you know how much you can lose at any given moment. That takes some pressure off, especially for day traders.
You know that you are limited to a maximum of 4 loses today (according to the numbers in the example above, where you risk 0.5% per trade and allow max risk of 2% per day).
This kind of risk profiling has another critical aspect. It keeps your drawdown under control, and drawdown even though it is a necessity, it could ruin you psychologically and emotionally.
Let’s take a look at the following table below. It shows us how much we will need to gain, in order to get back to break-even (no profit, no loss) after a losing period.
The numbers speak for themselves. The more you lose in %, the MORE you’ll have to gain back just to return to break even.
“If you find yourself in a hole, and you want out, stop digging!”
Not being consistent in your risk is another common mistake. If you change your risk per trade constantly you will not get far.
Many traders that had a winning streak of few trades, get their confidence skyrocketing and then take much bigger risks. Of course, at that stage losses will occur and they will find themselves with bigger losses than the profits they did before.
Another common mistake is – Not using a stop loss at all!
Not limiting your risk is a recipe for failure. If you don’t limit your risk, you may find yourself in real trouble.
Risk Reward Ratio
You invest (risk) $1 (for example) and you expect to win $2. This is what risk-reward ratio is about. How much are you willing to risk and what is your potential gain of this investment. This is another crucial part of your trading plan. Having a positive risk-reward ratio is highly recommended. Unfortunately, many traders do vice versa. Risk more than they expect in return. It’s a guaranteed recipe to failure.
As you probably already know, in forex we trade in pairs. There is a phenomenon called correlation among the pairs. Translated in simple words – when 1 pair is moving higher, the other will follow and do almost the same. That would be a positive correlation. On the other hand, would be negative. This means that if pair X is moving higher, pair Z would be moving lower.
So why are we talking about correlations?
Imagine you trade 0.5% per trade. You got your entry on pair X and you are happily waiting for the trade to develop. However, another entry appears on pair Y which is strongly correlated to pair X. If you trade this one as well, you are going to double the exposure. In essence, you will be trading pair X with 1% instead of 0.5 %. A very common behaviour in the GBP pairs for example. Usually, they form the same structures and the same setups. Keep that in mind next time you are planning to open multiple trades simultaneously. Don’t overexpose yourself to the same currency/instrument in different variations. It might turn sweet if you are right, but if you are wrong – it will turn very bitter.
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