Why risk management is important in Forex

The desire to make money is what got us interested in this market in the first place. However, before thinking about how we can make money and how much we want to make from the market, we need to be thinking about protecting what we already have. Which is our trading capital because if we lose it, then we’ve also lost the potential of making that profit

We’ll probably have to quit and won’t get the opportunity or simply wouldn’t want to trade again for a long time

Therefore, risk management in trading deals with understanding the factors that affects trading account and positioning in such a way to diminish our trading risks; it comprises the individual actions that allow traders to protect against the downside of a trade. More risk means higher chance of sizeable returns – but also a greater chance of significant losses

Without a risk management strategy in place, we’re basically gambling! Meaning we are not looking at the long-term return on our investment. Instead, we are only hoping for that “jackpot trade.”

When we have no control over our risk, it can become very easy to lose it all. It’s recognised that up to 90% - 95% of new traders lose cash in their first few trades and many of them will give up trading at that point. Risk management rules will not only protect our accounts, but it can also make us very profitable in the long run

Risk management is a concept that has existed for a long time and is relevant to all kinds of trading and all kinds of business ventures

What is risk management and why is it important?

Risk management is the term applied to a logical and systematic method of establishing the context, identifying, analysing, evaluating, treating, monitoring and communicating risks associated with any activity, function or process in a way that will enable organisations to minimise losses and maximize opportunities {source}

Therefore, effective risk management offers the potential to reduce both the possibility of a risk occurring and its potential impact. It provides a business with a basis upon which it can undertake sound decision-making

For a business, “assessment and management of risks” is the best way to prepare for eventualities that may come in the way of progress and growth. When a business evaluates it’s plan for handling potential threats and then develops structures to address them, it improves its odds of becoming a successful entity

Every business and organization faces the risk of unexpected, harmful events that can cost the company money or cause it to permanently close. Risk management allows organizations to attempt to prepare for the unexpected by minimizing risks and extra costs before they happen

The ability to understand and control risk enables organizations to be more confident in their business decisions

What is proper risk management in Trading?

In trading, risk management enables us to implement a set of rules and measures to ensure that any negative impact of a trade is manageable. Therefore, an effective risk management strategy requires proper planning from the outset, since it’s better to have a risk management plan in place before we actually start trading

Risk management is a technique applied to help cut down losses and protects a trader’s account from losing all of his or her money. After all, a trader who has generated substantial profits can still lose it all in just one or two bad trades without a proper risk management strategy. "Risk management could be a deciding factor on whether we’re a consistently profitable trader or losing trader"

Remember, we can have the best trading strategy in the world. But without proper risk management, we will still blow up our trading account. "It’s not a question of if, but when!"

It’s pretty common for new traders to think making money through trading is fast and easy. However, it’s a process that takes time, dedication, commitment, and patience, if we want to be successful and profitable in the markets in the long run

Our risk per trade should always be a small percentage of our total capital. A good starting percentage should be 1% of our available trading capital. i.e if we have $5000 in our trading account, the maximum loss allowable on a single trade should be no more than 1%. With these parameters our maximum loss would be $50 per trade. A 1% loss per trade would mean we can be wrong 100 times in a row before we wipe out our account. Which is an unlikely scenario if we have a proper system for stacking the odds in our favor

Don’t focus on making money; focus on protecting what you have. -Paul Tudor Jones

Some risk factors of trading:

The foreign exchange market is widely known as the biggest trading market in the world. It is also one of the easiest markets to start trading, yet the one that comes with various dangers and risks as well

The biggest and most obvious risk associated with Forex is "losing our funds." Everyone’s intentions entering the market is to gain payouts and be successful in trading, yet the average trader will most likely lose their money, according to various statistics

Now, while the risk of losing funds is straightforward, there are different variations of risk factors in trading that leads people to losses

We will discuss five of the most rampant factors that lead traders to failure:

• Unpredictable market volatility risk
• High leverage risk
• Interest rate risk
• Liquidity risk
• Untrustworthy counterparty

These individual factors can increase the dangers of trading Forex and losing your hard-earned funds. At the same time, these factors are the reason why Forex trading is profitable in the first place

For that reason, it is important to evaluate the risks and rewards before entering the market and make decisions accordingly

The risk of unpredictable market volatility;

One of the key characteristics of any financial market, be it Forex, stocks, commodities, etc is the continuous change of asset prices. Which is shortly known as volatility

On one hand, volatility is the main reason why traders are profitable. If the prices were static and unchanging, there would be no point in buying an asset; the whole point of trading is to buy a security at a lower price and sell it when the price increases. And without volatility, that would not have been possible

However, the change in asset prices can also make traders lose money. They may buy an asset at a certain price and expect to sell it at a higher price to get a payout, however, the market can easily go against them and drop the price, making it unprofitable to sell an asset at that point

The risks of Forex trading are even higher if the market volatility is skyrocketing. Spiking volatility can be caused by sudden and drastic economic or political news that greatly impact the market. Therefore, it is always a good idea to be careful about position sizes and not open exceedingly large trades

The risk of high leverage;

Leverage is also one of the inherent features of Forex. The majority of brokers offer it to their clients to make it easy for them to control larger position sizes

It goes without saying that an increased position also increases prospective payouts. Unfortunately, leverage acts as a double-edged sword because it can also increase the size of prospective losses

In short, using the leverage in your trades can be both beneficial and risky and it is up to you to choose the exact leverage ratio that you need

The risk of unexpected changes in interest rates;

The interest rate is yet another key characteristic of the currency market. It shows the percentage of returns people/institutions get for lending their money to others. It also has a big influence on currency exchange rates and presents one of the many risks of Forex investing

If the central bank of a certain country decides to increase the interest rate, it will automatically attract new demand for that currency: those people who want to make deposits or investments in that currency because it gives them larger payouts. For that reason, the currency will strengthen and its price will increase against other currencies

Conversely, if the central bank decides to decrease the interest rate, the demand for it will decrease as well. That’s because the deposits and investments in that currency will generate lower payouts than before. For that reason, the currency and its price against other currencies will weaken

The biggest risk associated with interest rates is their unexpected change. Sometimes, central banks take drastic measures that include unexpected increases/decreases in interest rates. This, in turn, has an effect on the exchange rate of a certain currency, and ultimately, it goes against the traders’ interests

The risk of low liquidity;

Forex is the most liquid market because there are always people who are ready to buy and sell currencies. This also means that individuals have little impact on the overall price of an asset because the scope of the market is so huge

Now, there are periods when even the most liquid Forex market can have low liquidity levels, which is yet another one of the FX Trading risks. Low liquidity levels usually occur during bank holidays, weekends, or financial crises, increasing the additional operational costs

Usually, when the market is less liquid, brokers tend to increase the size of spreads, which acts as a commission for their services. And as you may already know, large spreads reduce payouts received from trades, which is something that traders usually avoid

The risk of untrustworthy counterparty;

When entering the Forex market, or any market for that matter, one of the first thing traders do is find a service provider (a broker). The broker provides us with various tools and indicators that are necessary to conduct a trade. Besides, they connect traders to liquidity providers - the ones that give traders assets to trade

Unfortunately, one of the risks of trading is being treated poorly by the other party - be it a broker or a liquidity provider. This means not getting paid when you need/want to take the money from your account

The counterparty may be unable to pay you for various reasons. One of those reasons is that the liquidity provider simply defaulted or went bankrupt and has no financial means to pay you. But there are other cases when the counterparty isn’t obligated to pay you by any regulatory authority, therefore, it simply refuses to do that

Either way, it is vital to find a regulated broker that abides by high financial standards and has proper reserves to fulfill our requirements should the liquidity provider be unable to pay out earnings

Here’s my content to guide you on choosing the best Brokers for you

How can trading risk be reduced?

Here are a few risk management tips, which will help us reduce our risk regardless whether we are a new or professional trader:

• Educate yourself; If you are new to trading, you will need to educate yourself as much as possible. In fact, no matter how experience you are with the Forex market, there is always a new lesson to be learned! Keep reading and educating yourself on everything Forex related

Here’s my content to give you hints on some really good Books to read

• Use a stop loss; A stop loss is a tool which allows you to protect your trades from unexpected market movements by letting you set a predefined price at which your trade will automatically close. Therefore, if you enter a position in the market in hopes that the asset will increase in value, and it actually decreases, when the asset hits your stop loss price, the trade will close in order to prevent further losses. A good rule of thumb is to set our stop loss at a level. That means "we will lose no more than 1% or 2% of our trading balance for any given trade"
• Use a take profit to secure your profits; A take profit is a very similar tool to a stop loss, however, as the name suggests, it has the opposite purpose. Whilst a stop loss is designed to automatically close trades to prevent further losses, a take profit is designed to automatically close trades once they hit a certain profit level. By having clear expectations for each trade, not only can we set a profit target, and, therefore take profit when hit, but we can also decide what an appropriate level of risk is for the trade
• Do not risk more than you can afford to lose; One of the fundamental rules of risk management in trading is that you should never risk more than you can afford to lose. Despite it’s fundamentality, making the mistake of breaking this rule is extremely common, especially among those new to trading

The FX market is highly unpredictable, so traders who put at risk more than they can actually afford to lose, makes themselves very vulnerable

• Have realistic profit expectations; One of the reasons new traders take unnecessary risk is because their expectations are not realistic. They may think that aggressive trading will help them earn a return on their investment more quickly. However, the best traders make "steady returns." Setting realistic goals and maintaining a conservative approach is the right way to start trading. Being realistic goes hand in hand with admitting when you are wrong. It is essential to exit a position quickly when it becomes clear that you have made a bad trade. It is a natural human reaction to attempt to turn a bad situation into a good one, however, with trading, it is a mistake. With this mindset, we can prevent greed from coming into the equation, which can lead us into making poor trading decisions. Trading is not about opening a winning trade every minute or so, it is about opening the right trades at the right time, and closing such trades prematurely if the situation requires it
• Have a Forex trading plan; One of the big mistakes new traders make is signing into a trading platform and then making a trade based on nothing but instinct, or maybe something that they heard in the news, or social media that day. Whilst this may lead to a few lucky trades, that is all they are - luck. To properly manage our Forex risk, we need a trading plan that outlines at least the following:

1. When we will open a trade
2. When we will close it
3. Our minimum reward-to-risk ratio
4. The percentage of our account we are willing to risk per trade

Once you have devised your trading plan, stick to it in all situations. A trading plan will help us keep our emotions under control whilst trading and will also prevent us from over trading. With a plan, our entry and exit strategies are clearly defined and we will know when to take our gains or cut our losses without becoming fearful or feeling greedy. This approach will bring discipline into our trading, which is essential for good risk management

It stands to reason that the success or failure of any trading system will be determined by its performance in the long term. So be wary of apportioning too much importance to the success or failure of your current trade. Do not break, or even bend, the rules of your system to try and make your current trade work

FINAL THOUGHT

Like all aspects of trading, what works best with regards to risk management will vary according to our preferences and profile as a trader. Some traders are willing, and able, to tolerate more risk than others

If we are a beginner trader, then no matter who you are, the best tip to reduce your risk is to start conservatively. We recommend practising new strategies, in a risk-free environment, with a free demo trading account

A demo account is the perfect place for a beginner trader to get comfortable with trading, or for seasoned traders to practice. Whatever the purpose may be, a demo account is a necessity for the modern trader

(As we go forward one step at a time according to the roadmap, you’d see what I found useful and has experienced personally over the years about the idea of Demo trading)

"In the end, forex trading is a numbers game. Meaning we have to tilt every little factor in our favor as much as we can"

Trading is a BUSINESS - Treat it as such!!