The short version
- Forex trading is a very volatile and risky investment.
- Forex risk management helps investors limit risks from trading.
- To limit risk, traders should keep an eye on the news, understand the market, use stops and limits, build a trading plan, and manage their emotions.
- For investors just starting out, you can use a demo or paper trading account to try out strategies before you invest your own money.
What is forex risk management?
Forex risk management strategies help limit the negative impacts related to any trade you make. Whenever you trade forex, you’re open to risks that can lead to losses. Successful trading includes mitigating some of those risks, as well as planning ahead to create rules and parameters for your trading.
What are the risks of forex trading?
If you decide you want to move forward, understanding forex trading risk is vital. Here are some of the things you need to watch out for as you start forex trading:
- Leverage risk: One of the biggest forex trading risks is leverage. Many traders use margin — which is a way of borrowing money for trades — to magnify their gains. With leverage, it’s possible to enter bigger positions and take profits on small price movements. However, leverage is a double-edged sword that can magnify your losses as well as your gains.
- Exchange rate risk: The value of currencies relative to each other is always fluctuating. Prices change constantly, so forex traders run the risk of volatility in the middle of a trade. When using international forex markets, you’ll see increased risk due to the purchase and sale price of different currencies.
- Liquidity risk: Generally, the currency market is highly liquid. However, there are times when government policies and other factors can make it harder to complete a transaction. If you can’t execute a trade fast enough to profit, you run the risk of piling up losses.
- Interest rate risk: The rise and fall of interest rates impacts currency prices. Rapid changes in rates, as well as policy, can add to the volatility of the forex market.
- Excitement: One of the risks of forex trading is the excitement you may feel while trading. It can be easy to get addicted to the rush and over-trade, or to attempt to run your profits when you should be taking them. This can lead to long-term losses.
How to manage risk in forex trading
Forex risk management requires setting parameters and putting together a plan designed to help you limit your losses. Here are some of the risk management strategies that might help you make the most of your forex trading:
Understand the forex market
Your first step is to understand the forex market. Take time to research how it works and the ways trades are executed. When you know how the market works, and understand currency trading, you’re more likely to make better decisions and reduce the chance of losses through ignorance.
Determine your risk tolerance
Next, determine your risk tolerance. Be realistic about how much you can afford to lose. Take a look at your financial risk tolerance and limit how much money you’ll put into forex trading. This is one of the best forex risk management approaches. Be clear about how much you’ll spend on trading — and stop when you reach that number.
Get a grasp on leverage
Understand how leverage works and how it can impact your losses, as well as your gains. While you can amplify your profits with the help of margin trading, there's also potential to lose big. Then, determine how much leverage makes sense based on your risk tolerance.
Build a trading plan
Once you know the market, understand leverage and know your own risk tolerance, it’s time to build a trading plan. A good trading plan should include when and how you’ll trade, as well as what indicators you’ll focus on. You should also have an idea of when you’ll take profits and when you’ll reinvest.
If you stick to your plan, you’ll be less likely to lose money on your trades. If you do lose money, sticking to your plan can help you limit your losses.
Customize your contracts
Depending on the platform you use, it’s possible to customize your contracts to fit your parameters and trading plan. Try to create contracts that increase your chances of profit while keeping your downside risk limited to what you can handle.
Set a risk-reward ratio
One of the best risk management strategies is to create a risk-reward ratio. Figure out how much you’re willing to lose on each trade — perhaps you’re willing to lose $150 for each trade. Next, set your target for taking a profit, say, once you’re profiting, $300. This creates a risk-reward ratio of 1:2. You don’t have to be profitable on all your trades when you have a risk-reward ratio that works for you.
In this case, you could lose on six trades, to an amount of $900 in losses, and still come out ahead if you take $1,200 on the remaining four trades. You have a profit of $300, not counting fees and other costs, even though you lost on more trades than you won on.
Use stops and limits
Stop loss and limit orders can help you cut off losses if things go bad. When you enter a position, make sure to set a limit or stop loss order so that you don’t end up losing more than you can afford.
Manage your emotions
While it’s easy to get emotional, it’s important to manage your emotions while trading to avoid making decisions with cloudy judgment. Stick to your plan and take profits when you’ve determined to. When you stop your losses or take your profits and move on, you’re more likely to come out ahead in the long run.
Avoid weekend gaps
The forex market is open 24/7 and prices are always moving — even during the weekend. If you have an open position on Friday, prices could move drastically over the weekend and you could wake up Monday to a nasty surprise if you aren’t careful. Consider exiting your position before the weekend if you aren’t going to keep trading.
Make it affordable
Be sure that you’re making your trading affordable. This means only risking money you can afford to use and being careful with margin. Once you get into a good rhythm, this can also mean only trading with profits you’ve taken on previous trades, rather than adding new money to your account.
Keep an eye on news and events
Any type of active trading, but especially forex trading, is going to be impacted by current events. Watch what’s going on so you can exit a position early if it looks like the forex trading risk is mounting due to political and economic events.
Start with a demo account
Finally, there can be a learning curve when getting the hang of trading. Without prior practice, this can result in losses when you first start. You can use a demo account, like TD Ameritrade‘s thinkorswim platform, and get a hang of the platform. And try out different strategies before you risk your cash.
Forex trading can be an exciting and profitable way to make money. However, you have to be aware of the risks associated with forex trading. Take steps to implement a risk management strategy so you don’t end up losing more than you can afford. If you have a strategy, then you will have better control over your portfolio.