Excitement, anxiety, disappointment, elation – these are some examples of the emotions that can be experienced when trading, sometimes all within the space of the first few minutes!
Welcome to the world of retail forex trading where there will be highs and lows in what can be a rewarding but challenging pursuit for seasoned traders or beginner investors alike.
One of the main challenges is knowing how to effectively manage the risk on your trading account. Because while profitability when trading is the key objective, equally important, is the ability to protect your capital when faced with unfavourable market moves. Effective use of Stop Loss and Take Profit orders as part of an overall trading strategy is a simple way to do this.
But before entering a trade, it’s important to ‘do the maths’ and ask yourself two fundamental questions:
By answering these questions, you can determine where to place your Stop Loss and Take Profit targets.
In this article, we will discuss what risk management is and why it is important, as well as some of the most commonly used risk management strategies that can help you improve your trading performance. But first, let's kick off with the basics!
Risk management is one of the most important components of a trading plan and it can make the difference between gambling and trading. Placing trades without consideration of the risks involved is gambling. On the other hand, trading is all about taking calculated risks - trying to minimise losses while maximising profits.
Risk management is essentially a set of rules that are designed to minimise your losses and maintain a reasonable risk/reward ratio when placing trades.
First of all, you should understand what type of trader you are and understand your own risk appetite. Some traders are keen to take larger risks in exchange for a higher potential profit. On the other hand, some traders are more risk averse and prefer to keep their risk low.
Identifying your risk appetite will help you determine how much you should risk per trade. While aggressive traders might risk 2-3% of their account balance per trade, conservative traders might prefer to go for 0.5-1.0% per trade.
One of the biggest risks in forex trading is leverage. While leverage can help you increase your profits, it can also magnify your losses. There is a reason leverage is often called a "double-edged sword".
Just as a credit card can allow you to spend much more than you have in funds in your bank account, leverage allows you to control a position of a significant size compared to your actual account balance. The higher the leverage, the higher the risk that you could lose all your capital.
Another risk is liquidity. One example of this is the market opening on Sunday evening (NY Time). Liquidity will be extremely thin and there is a serious risk of a significant weekend gap. Traders can be caught by surprise, especially if there was an unexpected event that occurred over the weekend while the market was closed. However, liquidity can disappear even during weekdays, when the markets are open. This exposes traders to slippage when entering and closing positions.
Furthermore, technology risk can also affect traders. It could be minor issues such as the internet connection in your home failing. While this would have been a disaster for traders two decades ago, most traders have a version of their trading platform installed on their mobile devices. On the other hand, your broker may experience a major outage, which could prevent you from accessing the platform and therefore managing your positions. This would be a far more serious issue, as you would be unable to control your positions regardless of which device you are using. Luckily, such outages are rather rare and are quickly fixed.
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Once you have a good idea about your personal risk appetite, you should start incorporating risk management into your trading plan. This means defining how much you want to risk per trade and planning your entry and exit strategies.
Trading without a stop and/or take profit can be dangerous, especially for beginners. You could be tempted to break your rules and let the losing positions run in the hope they will turn profitable in the end. Having well-defined rules and a stop loss order in place can help you manage your risk efficiently.
Ultimately, emotions cannot be eliminated from trading, but they can be controlled with enough practice. Having a clear trading plan will help you accomplish this as you will become more disciplined over time.
With this, it is important to have realistic expectations about what you can achieve. You cannot achieve a monthly return of 50% without taking excessive risks and the risk of blowing up your account is significant. Having more realistic goals - such as achieving a return of e.g. 3% per month - will help you in keeping your emotions under control.
Furthermore, you should not limit yourself to only one market. If you are using a trend strategy but the forex market has been in a stubborn consolidation phase that just won't end, it might be time to look at other asset classes such as share CFDs, commodities or indices.
Let's look at an example to see how you can effectively manage risk while trading the forex markets.
Let’s assume you have AU$10,000 in your trading account. You’ve decided that you think the AUDUSD rate is going to go higher, so you want to buy this currency pair.
You’ve also decided to use 5% of your trading account value as a margin requirement to cover this trade, which equals an amount of AU$500 (10000 x 0.05 = 500).
You then decide to trade AUDUSD at a margin rate of 1%, or in other words, using a leverage ratio of 100:1. This means that with AU$500 worth of margin you can open a position size of 50,000 AUDUSD (500 is 1% of the overall position size, so multiplying this by 100 will give us the total position size of 50000).
To enter the trade using a 1% margin rate, you place a Market Order to buy 50,000 AUDUSD @ 0.7250, which is the current market price.
After working out how much margin you want to use (which then determines the trade size), you need to work out how much of the account balance you’re willing to risk on the trade. The answer to this will vary from trader to trader, and it will depend on your risk tolerance.
A general rule of thumb is to not risk more than 2% on any one trade. Once you’re comfortable knowing how much of your account you’re willing to risk, you can then work out where to place your Stop Loss order.
Back to the trading example – if there’s AU$10,000 in the trading account, and you’re using AU$500 as margin to open a long 50,000 AUDUSD position, using 2% as the guideline means you’re willing to risk losing AU$200 on the trade.
At this point it’s worth remembering that profit and loss on a trade is generated in terms of the secondary currency, which in this case is the US Dollar (because it’s listed second in the AUDUSD pair). So, before placing a Stop Loss, you need to work out what the equivalent of AU$200 is in USD. Based on an exchange rate in this example of 0.7250, the answer is US$145 (200 x 0.7250 = 145).
In a trade size of 50,000 AUDUSD, every 1 pip movement (a movement in the 4th decimal place for AUDUSD) equates to a profit/loss of US$5 (50,000 x 0.0001 = US$5). If you’re willing to risk AU$200, which is US$145, it means our Stop Loss should be placed 29 pips away from the entry price (145/5 = 29 pips).
Therefore, based on the trade entry price of 0.7250, a Stop Loss would then be placed 29 pips away (or 0.0029) at 0.7221 (0.7250 – 0.0029 = 0.7221).
Using a Trailing Stop can also be a good choice, as the Stop will ‘trail’ favourable price movements while limiting the scope for downside losses.
For example, a Trailing Stop loss could be set with an initial level at 0.7221, but with a trailing level of 29 pips, meaning that under certain conditions (such as the price moving higher but not high enough to trigger your Take Profit order) you could then be stopped out at your entry point of 0.7250 with a zero loss. But it’s worth remembering that there are advantages and disadvantages to using Trailing Stops, so while there are situations where they will add another level of protection to your capital, they can potentially also cut you out of a trade that otherwise would have triggered your Take Profit level.
Once you know where to place the Stop Order (in accordance with how much you’re willing to risk on the trade), the next thing to consider is where to place the Take Profit order. The answer to this will depend upon what sort of Risk/Reward ratio you decide to have.
For the purposes of illustration, let’s assume we use a 1:2 Risk/Reward ratio, which would mean that you would be risking AU$200 in trying to achieve an AU$400 profit. In practical terms, this would mean if our stop is placed 29 pips below the entry price, the Take Profit would be placed 58 pips (i.e. double the Stop Loss distance) above the entry price at the level of 0.7308.
To recap the entire hypothetical trade set-up:
In addition to using Stop Loss and Take Profit orders to manage your risk when trading, you can also make use of the Price Alerts function to stay informed of price movements.
While it’s true that we can’t control price movements in the forex market, we can control the profit and loss parameters we set up around the trade.
By setting Stop Loss and Take Profit orders in accordance with your trading objectives, you can have a risk management approach that not only allows you to take advantage of the profitable trading opportunities in the FX market, but one that also enables you to limit the losses when trades don’t go your way. It’s all part of the highs and lows of forex trading.
To learn more about the forex market and practicing risk management, check out our absolutely FREE online trading course: Introduction to Forex Trading!
The information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. Readers should seek their own advice. Reproduction or redistribution of this information is not permitted.
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