Importance of Risk Management
The ability to manage risk is ultimately what separates Forex traders. Those with poor risk management may have bouts of success here and there – however, this is not a viable long-term success plan.
Risk management is that understanding that your trading account should be treated like an investment. It is more so like a business rather than a casino game. The sudden or large loss of money is a very real occurrence. Risk management is essential.
What Is Risk Management?
Risk management is simply the understanding and balancing of potentially profitable risk against those that are not. Without taking on risk, one’s potential earnings will be miniscule. However, taking on too much could potentially deplete one’s entire funds. Subsequently, risk management is about limiting one’s risk exposure.
What can you do to manage risk?
There are several tools, approaches or processes that can help you manage your risk exposure. Some of these need to be done prior to starting trading and some whence orders are made.
The below are some steps you can take to manage your risk levels.
Step 1: Determine your level of trading risk
When trading, it is very easy to be distracted and driven simply by the potential gains alone. Traders need to be able to also look at the potential losses that could take place in their trading. A simple way to determine ideal levels of risk is by using a Risk: Reward Ratio.
What is a Risk: Reward Ratio
The Risk: Reward Ratio is used to compare expected returns on an investment against the amount of potential loss on those returns. It is calculated by dividing the amount of profit expected when the position closes (reward) by the amount the trader stands to lose if the price moves in an unexpected direction (risk).
What is a good risk-reward ratio?
- Better/ safer ratio – 1:3 or 1:4
- Acceptable ratio – 1:2
- Risky/Unacceptable – 1:1 or 2:1
- Sell Stop Loss Order
- Stop Limit Order
- Buy Stop Loss Order
- Trailing Stop Loss
- Trailing Stop Limit Order
- Bracket Order
Step 2: Place Stop Loss Orders
A stop loss order are those orders which have conditional rules which determine when they open or close.
With Forex being leveraged products, fluctuations and changes can magnify both wins and losses. In uncertain and volatile economic times, it is ideal to use stop losses to manage such unforeseen movements minimising your overall risk exposure.
Instead of just simply placing market orders, place pending orders with stop loss conditions. You can also add stop loss conditions on market orders already placed.
Some stop loss conditions you can use include:
Step 3: Take profits early on
A cautious yet rewarding technique involves removing any profits from a winning trade. Rather than waiting to see if you can gain more (at the risk of a turning market), take the profits when they are at a suitable level or when they match your risk: reward ratio.
You can also set Take Profit conditions on your pending trades or modify existing market orders to take profits for you automatically when they reach a certain point.
Another way to you can take profits early to minimise risk is to do a partial close. If you feel that the market may still be profitable, take the profit on part of a trade and leave the rest open. Here, you have managed to take some profit whilst still minimising your overall risk exposure.
How much risk you are willing to take is closely linked to your trading psychology. Read our section on Trading Psychology to see steps on how to balance your risk levels against fear and greed.
If you’re feeling ready – start your practice with a free MT4 Demo Account today. If you need help or have any questions, feel free to contact one of our account managers or see our FAQ Support Centre.