A Complete Guide To Risk Management In Forex Trading

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One thing that you sign up for when you decide to become a forex trader is the risk of losses. But you should not be hesitant to take the risk as it also gives us a chance to make profits from trading. Both the risk and reward of forex trading can be attributed to the volatile nature of currencies and that volatility is essential to find profitable trading opportunities. Now, dealing with the risk can be a stressful experience for a beginner and that’s why you need to master the art of risk management before stepping into the dynamic forex market.

In this guide, you will learn about the risks associated with forex trading along with the techniques for managing the risk in the best possible manner. 

Risks Associated with Forex Trading

The risks that you have to deal with as a forex trader can be categorised as market risk, leverage risk and country risk. Market risk can be described as the risk of loss due to unfavourable price fluctuations caused by market conditions. This can be related to the fundamental forces that drive the forex market and currency pair prices. For instance, you see that the US is about to make a deal with Japan which can lead to appreciation of USD. Hence, you decide to go long on the USD/JPY pair. 

But later the deal gets cancelled and the Eurozone manages to seal the deal instead. Thus, the price of the pair ends up dropping as USD loses momentum due to the sudden change. Such risks can be referred to as market risk in forex and you should be prepared to face such situations while entering trades ahead of a key economic event or news release. 

The 2nd risk associated with forex trading is leverage risk and it happens when you are trading with leverage for maximising the gains but there is a possibility of the market moving against your expectation, amplifying the losses. Using excess leverage can increase this risk and another risk that arises with the use of leverage is the possibility of a margin call. You should always calculate the margin requirement before entering a trade and a margin calculator can be used to simplify the calculation task. 

The 3rd risk that you need to know about before trading forex is country risk. It is related to the economic state and political situation of the country that is the issuer of a currency that you are trading with. The country risk can also be associated with your own country in some situations. This can be a war or a natural disaster that causes a depreciation in the currency’s value affecting the currency pair prices.  

How to deal with the risks? 

• Mitigating market risk – Market risk is something that no trader can escape and it applies to all financial markets and trading instruments. However, some currency pairs are more susceptible to this risk due to their volatile nature or during times when there is an increase in volatility. For instance, exotic pairs are the riskiest pairs to trade with as they put the traders in a dangerous position due to the high volatility and low liquidity, making it harder to enter and exit trades at favourable prices. 

On the other hand, major and minor pairs are considered to be less risky as they are more stable and the high liquidity makes the trading process easier. Major pairs are the safest when it comes to trading and thus all beginners are advised to start trading with a major pair only. But irrespective of the pair, you need to manage the market risk by making informed trading decisions based on detailed analysis. 

Just technical analysis alone may not be enough to predict the potential price movements as fundamental factors play a key role in market fluctuations which may not be identifiable from the price charts. But tools like pip calculators can be used to calculate and manage the risk based on the price movements that you see on the chart. Because the price movements are measured in pips you need to consider pip value while planning your trades. 

• Limiting Leverage Risk – When it comes to dealing with leverage risk, the only thing you can do is use limited leverage as leverage will always increase your exposure to risk. Those who are not ready to take the risk that comes with opening large-sized trades with smaller margins should avoid using leverage in their trades. You can just trade with the money that you already have in your account without the added risk. 

However, this may not be practical for all traders as many of us need to use leverage to optimise the profit potential. Otherwise, you may not be able to grow your accounts even with the perfect strategy that performs well. Hence, you don’t need to avoid leverage altogether but make sure you don’t use excess leverage and always prioritise risk management.  

You should always make sure that there is enough margin in your account while placing trades and make sure that the position sizing is optimal based on your risk tolerance. This way, you can limit the potential losses and account drawdown. 

• Managing Country Risk – Dealing with the country’s risk is harder as the economic and political events that affect the forex market can happen without any warning. It may not be possible to predict the impact of such events in advance and you need to keep an eye on the news to avoid placing trades when the situation is unfavourable. 

Strategies like news trading can be profitable when you have enough experience in the forex market. But beginners should wait until the market responds to the event that has happened before making any trading decision. 

Other Risk Management Techniques

Aside from the methods to deal with the market risk, leverage risk and country risk, there are some other risk management techniques that all traders need to use for minimising the potential losses. Firstly, you need to ensure that all your trading decisions are based on detailed analysis and calculations. Because even a small error can lead to costly mistakes in trading. While calculating the trade-related metrics, it would be ideal to use tools like trading calculators which provide instant and accurate results, saving your time and effort. Using an automated calculator helps to eliminate the risk of manual errors. 

• Setting a risk/reward ratio – One risk management technique that you can apply in trading is having an optimal risk/reward ratio that allows you to maximise the gains with limited risk. An ideal risk/reward ratio will allow you to find favourable trading opportunities and you will be able to make enough profits even with a low win rate. 

• Placing a stop loss – Placing a stop loss for every trade is one rule that you should never break in forex trading. You may be confident about the probability of winning a trade, but you still need to prepare for the worst-case scenario. A stop loss works like an automated exit when a trade goes into loss and it functions as a safety net that protects your account from excess losses. 

The importance of sticking to your plan 

Risk management is not just about how you manage the risk but it is also about how well you can execute your trading strategy. Many traders end up deviating from their strategy or plan due to various reasons and this always increases the risk of losses. Hence sticking to your plan is important for dealing with the risk. I am going to share some tips that you can follow to avoid common trading pitfalls. 

• Managing your emotions – A  major cause of poor trading decisions is a lack of emotional control as we are prone to making mistakes under the influence of emotions. Emotions like greed and fear are commonly experienced by traders and you may fail to think rationally while dealing with such intense emotions in the middle of a trade. So, it is important that you learn to manage these emotions and avoid making any trading decisions when you are stressed. 

• Diversification – Another thing that you need to manage the risk is diversification. In the initial phase, all traders are suggested to focus on one currency pair to make the trading process easier. But as you gather experience, you need to trade with multiple pairs and even explore other asset classes to minimise the risk with diversification. You need to be careful about how you allocate your capital to different trades. Your risk per trade should be limited and you should never risk more than 2% of your account balance in a single trade. 

• Having realistic expectations – The reason behind many traders taking excess risk is their unrealistic expectations for profits as they think of forex trading as a method for making easy money. So, you need to trade with realistic expectations and only trade with the money that you can afford to lose. 

Wrapping Up

In the end, risk management is something that each and every trader needs to learn about before risking real money. One method that you can use for studying about it is demo trading as you get to trade with virtual funds while devising your strategy and risk management plan. This allows you to understand the impact of risk in real-time market conditions and come up with a plan to manage the risk based on your trading goals and risk tolerance. After that, you can start trading on a live account with a cautious approach to deal with the risk.