What is Risk Management in Forex?

One of the most important topics in forex trading is risk management. Why? Well, you are in the forex business to make money. And, to make money, you have to learn how to take acceptable losses and manage risk in the live market.

Surprisingly, this is one of the most neglected lessons in all of forex trading. The reasons for the oversight vary from not understanding leverage to flat-out greed. In many cases, traders are just too excited to get started and completely disregard their account size! This is a major mistake and one that can cost a great deal of trading capital – fast.

Fortunately, there’s a way to avoid the perils of risk in the forex market. It’s called having a comprehensive forex trading plan.

What is Risk Management?

In finance, the risk is defined as being “the potential for the actual return on investment to be lower than the expected return.” To put it another way, it’s the chance of suffering a capital loss rather than a capital gain.

what is risk management, forex trading

Thus, risk management can be defined as a set of rules and measures you can put in place to ensure that the impact of being wrong is manageable. This includes the potential for loss and – if you’re trading using leverage – the potential to lose even more than you put in.

At the end of the day, Forex is a numbers game. And, in order to win, you have to tilt as many factors as you can in your favour. Don’t worry, there’s good news: risk management strategies can help you eliminate the chance of financial ruin while pursuing reward in the market.

Always remember, you want to be a part of the 1%, not a gambler. In most cases, gamblers have trouble paying the rent while one-percenter owns the building. Over the long run, it’s always better to be a consistent winner and have a shot at joining the 1%.

Manage Risk With A Forex Trading Plan

No matter what you’re are doing in life, it always helps to have a plan. From being an executive at the US National Futures Association to an investment business entrepreneur, having a path forward is integral to success. Forex trading is no different – to be a long-term winner you must know where you are going and how to get there.

For forex traders, having a comprehensive trading plan is an essential part of engaging the market competently. Accordingly, a good forex market plan does three things: it identifies an opportunity, promotes consistency, and helps manage risk.

Let’s take a look at these three facets of the forex trading plan and how they are crucial to making money via FX trading.

Finding Trading Opportunities

Perhaps the most difficult part of active trading is finding solid opportunities in real-time. The forex market is dynamic in nature; staying on top of all the action can be an epic task. That’s why having a framework for identifying market entry points is imperative.

In forex trading, there are countless ways of spotting trade setups. The real question is how do I spot those with a high probability of success?  Basically, there are two perspectives by which to evaluate the opportunity in the FX market:

  • Fundamental: Market fundamentals can bring pricing volatility and profit potential to any currency pair. Items such as central bank decisions, geopolitics, market news, and economic performance can create major opportunities.
  • Technical: In the modern market, technical trading strategies are king. The study of past and present price action is one way that many forex traders spot good trades. So, if you fancy yourself a foreign currency market technician, get out your price charts and indicators!

The bottom line is this: your forex trading plan should identify trade setups as price action unfolds. Upon a positive expectation trade being identified, it can then be acted on in a structured, disciplined manner.

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Risk Management in Forex Trading

Within the realm of forex trading, the meaning of risk management depends upon context. As it pertains to the trading plan, the term refers to maximising the potential of your trading capital on a trade-by-trade basis. By doing so, we can vastly reduce the significant risk of trading highly leveraged currency pairs.

Every good forex trading plan has a set of risk management rules. These rules outline the parameters for the following:

  • Maximum Per Trade Loss: The maximum loss on a given trade is defined before you start trading. This is a hard-dollar figure that is non-negotiable. There are many hard-dollar risk management strategies, but 1-3% of the trading account balance is widely accepted.
  • Applied Leverage: The position size is defined by the trading plan. It’s crucial to understand that margin carries significant risk; that’s why precision is necessary when determining how many lots to buy or sell at a given time.
  • Risk Vs Reward: The placement of stop loss and profit target orders is a key aspect of risk management. Each must be aligned relative to the current market price, acceptable per trade loss, and applied leverage. If done correctly, even the most erratic market moves will have a minimal impact on the trading account balance.

Truthfully, there are countless in-market risk management strategies. However, each of them addresses the three elements listed above. Be sure not to overlook these factors when building a risk management plan of your own!

Consistency

At the end of the day, it doesn’t matter if you rely on fundamental or technical analysis to identify forex trading opportunities. What does matter is that you act in a consistent fashion? Consistency is a key element of risk management; without it, you’re doomed to repeat the same costly mistakes over and over. Not even the best trading platform on the planet can make up for the cost of inconsistent trading!

Ultimately, the purpose of a forex trading plan is to optimise your performance in the forex markets. The frequent buying and selling of currency pairs is not an easy task! Having a concrete strategy that governs market entry/exit, position management, and risk management is the key to being a consistently profitable forex trader.

Avoid Gambling On The Forex Market

The “powers that be” have gone to great lengths to ensure that active trading isn’t viewed as gambling. Governing bodies such as the National Futures Association, Commodities Futures Trading Commission, and Securities Exchange Commission are all tasked with preserving the integrity of the marketplace. But, the question remains: Is forex trading gambling?!

risk management rules, forex trading

Well, it certainly can be! If you rush headlong into the world’s currency markets without a forex trading strategy, then SPOILER ALERT, you’re GAMBLING!  Just like when people go to Las Vegas to gamble their money in hopes of winning a big wad of cash…it rarely comes up ACES! Feel free to seek independent advice on this one – I’m sure that the experts will concur!

The primary difference between rock-solid forex trading and gambling is philosophy. When you gamble, you’re looking for a jackpot, not consistent returns. Conversely, when you buy and sell any currency pair while adhering to a comprehensive forex trading plan, you’re in it for the long haul.

Don’t get us wrong, there’s a time and a place for gambling. If Andrew Lockwood gets red hot and wins a $500,000 jackpot, he’ll be a happy guy. But, the casinos know that there will be thousands of other players who won’t, keeping them in business.

Do you want to know how the 1% of winning foreign exchange market players sustain their edge? Re-read the article above! They understand and aggressively pursue risk management. It’s as simple as that.

Summary

The global foreign exchange market is not a risk-free environment. There’s peril around every corner and always a pitfall on the immediate horizon. That being said, forex trading is a fantastic way to profit from discipline, aptitude, and know-how. 

Risk management is one of the most important lessons in all FX trading.  Some of the best investment advice ever given was “be sure to manage risk!” If you do so, you too can join the ranks of winning forex traders.

On to the next lesson!