What Is Risk Management In Forex Trading – How Do You Implement It?

 One common piece of advice that every beginner gets while entering the forex market is to start with a demo account first. A free demo account replicates the features of an actual trading account allowing you to practise in a simulated space. This is the perfect place to practise without any stress as you won’t have to worry about mistakes and goof-ups that happen as you learn to trade forex from scratch. You don’t have to deposit a single penny and can use the virtual money to place orders. The results you get at the end of each trade give you a glimpse of the potential outcomes. All platforms support demo trading, but most traders choose MT4 due to its user-friendly interface and the presence of all the necessary tools. You can download the app on your phone or computer, or you can even use the web trader version of the platform.  

 The risk-free environment is ideal for developing your skills as a novice trader with no prior experience. But the moment you switch to a live account where real money is used, you cannot escape the risk. Being a successful trader is all about your ability to withstand the market risk and manage it efficiently. Hence, you must spare some time to understand the role of risk management in forex trading and how to apply it when you start trading for real. 

This informative blog covers all the key aspects of risk management, helping you to walk on the road to success as a forex trader.

Different Levels of Risk Management 

Risk management is a vast topic and some newbies struggle to comprehend too. It is not that complex but you must be aware of the types of risk that you will encounter while trading forex currency pairs. There is volatility risk due to the frequent price movements that happen and country risk, which appears when you trade the currencies of different economies. The economic situation of a nation can shift at any time as the geo-political factors and even environmental issues can have a huge impact on the economic state.

The value of a currency can rise and fall with the strengthening and weakening of the economy that it belongs to. So, we need to manage the risk on a fundamental level which many forget as they only assess risk through technical analysis of the market scenario. So, you have to research and read about all the risks involved in currency trading and devise a sound strategy to cope with them. Ignorance is surely not bliss when you are being exposed to the risk of loss and arrogance leads you astray.

 To simplify the theory of risk management, it can be broken down into three levels. When you learn to apply this in actual trading, you can surely safeguard your trading capital.

1. Asset Allocation and Diversification

 The first level is asset allocation and diversification. How much money you will use for trading in the forex market must be decided before you sign up for a trading account. It is wise to mark a humble beginning as you are not yet ready to risk a huge amount. The capital requirement for forex trading is lower than other asset classes and you can get started with just $100 or less. You should only use a portion of your fund for forex as only investing in one asset is not the best approach.

 You can explore multiple markets or diversify within the forex market by trading multiple currency pairs. Diversification not only helps in mitigating the risk but it also optimises the profit potential. Another way to diversify and reduce the risk in forex trading is investing in managed forex accounts, where you earn without trading yourself. An expert trader of your choice will enter and exit trades on your behalf and they are known as account/fund managers.  

 Forex MAM/PAMM accounts are apt to make profits with minimal risk and all you have to do is smartly allocate your funds by choosing the best fund managers.  For this, you have to pick a trusted platform that offers managed account services and select the fund managers based on their performance. You should also check if their trading system and strategy are in line with your risk tolerance and profit targets. But if you are planning to trade on your own, you will have more to do to minimise the risk.

2. Strategy For Risk Management

 You need a sound trading plan to make trading decisions that align with your trading goals. You have to follow a well-defined strategy which outlines the conditions that have to be met for choosing the ideal trade setup. The second level of risk management is focused on personalising the trading plan and strategy in a way that the level of risk you take is tolerable. No strategy can guarantee a 100% win rate and the losses are unavoidable at times.

But you do have some control over the risk based on the trading style, timeframe and currency pairs you choose for trading. For example, scalping and day trading are popular due to the high profit potential and both trading styles are perfect for those who want to make quick profits in a short period. But they are very intense and only suitable for those who have professional-level skills. Beginners may find swing trading or positional trading to be less stressful and safer except for the overnight risk. 

3. Risk Management Per Trade 

Having a solid strategy can cut down the potential losses to a great extent but the risk per trade has to be controlled by the traders themselves. Firstly, you have to set a limit to the number of trades you will enter for a day or week and stick to it to avoid overtrading. You should also limit the amount of leverage that you use for a trade as it not only can generate high rewards but also lead to a higher account drawdown. You should only risk 2% or less of your total account balance for a single trade.

 Setting a risk/reward ratio is important to balance the gains and losses. You should never take a big risk for a small profit. The ideal risk/reward ratio is 1:2 or higher. You should never open a trade when the risk/reward ratio is less than 1:1. Because in such a case, the reward you get from the trade is not worth the risk. A higher win rate alone cannot lead to success if your risk/reward ratio is not optimal.

 But if you have a favourable risk/reward ratio, your gains will be higher even with a low win rate as you are not losing much. Another thing to do to manage the risk is to place a stop loss. It can be a regular stop loss to exit losing trades quickly or a trailing stop loss that preserves your profits.

The Bottom Line 

In the end, a forex trader must accept the fact that they cannot control the market direction or make an accurate prediction about price movements. The only thing you can control is the risk that you are taking and for that, you have to manage the risk. This is the secret formula that you need for success in trading.