It is a common misconception among new forex traders that making money through trading currencies is easy. However, the truth is that achieving success requires time, dedication and most importantly patience. And you know what is the most important element of success in trading? It’s risk management. If you are a trader your focus should not solely be on making money, but rather on protecting what you already have. Most beginners start live trading only after they have spent a few months on a demo account. Since there are no real stakes on demo accounts, they often miss out on implementing risk management and carry this poor habit to real trading. This leads to losses and blown-up accounts. To overcome this, they should set up some rules and trade according to them. Moreover, they should also bring into use different trading tools to find exact values related to their trades. We, in this article, will discuss some important risk management strategies that can help you safely take your profits home.
#1 Only Trade Money You Don’t Need
Risk only what you can afford to lose- you must have heard this phrase a number of times but do you stick to it everytime? If your answer is ‘No’, then you should really promise yourself to follow this rule from this moment onwards. Why? Well, there are a number of reasons. Let’s take an example of gambling, though trading and gambling are completely different from each other but for the sake of understanding let’s assume you are gambling in a casino.
Would you take all of your money and bet it on a single outcome? No, right? The same principle applies to trading. There is always a possibility of losing all of your trading capital. Moreover, trading with funds that you rely on for living expenses adds extra pressure and emotional stress. This can impair your decision-making abilities and increase the likelihood of making mistakes. Once you end your trading day, calculate what you have made in a day accurately using a profit calculator and note them down in a journal so that you know if you are going in the right direction or not.
#2 Always Use Stop-loss and Limit Orders
Forex market is extremely volatile where the value of currencies can go up and down in no time. Does that mean you have to monitor the prices 24/7? Fortunately, not. You can set stop-loss and limit orders. With these orders, you can give instructions to your broker to execute a trade when the price of the asset reaches a specific level in the market.
A stop-loss order is placed on an open position to protect you from excessive losses if the market moves against your trade. It prevents further losses beyond a certain point.
There are three important reasons why it's advisable to set stop-losses and limit orders for every trade. Firstly, it's a matter of common sense to protect yourself from potential downside risks. By setting a stop-loss order, you limit the amount you can lose on a trade, ensuring that your losses are controlled.
Secondly, having stop-loss and limit orders in place improves your mindset as a trader. When you know there is a level of protection for your trades, you can step away from the trading screen with peace of mind, knowing that your risk is managed.
Lastly, the process of setting these orders helps you evaluate and assess your trade against your trading plan. It serves as a checkpoint to ensure that your trade aligns with your overall strategy and objectives. By implementing stop-loss and limit orders, you can make more informed decisions and stay disciplined in your trading approach.
#3 Think About Your Risk Tolerance
While considering your risk tolerance, you should consider factors such as your age, knowledge of forex trading, experience, willingness to accept losses, and trading goals.
Determining your risk tolerance goes beyond just seeking peace of mind or reducing stress caused by currency fluctuations. It empowers you to maintain control over your trading activities by ensuring that you are allocating an appropriate amount of money based on your personal financial situation and desired financial objectives.
An easy way to determine potential risk in a trade is by using a pip calculator that automatically calculates the pips in your base currency. So, once you have the idea of the number of pips you need to earn, you can manage your risks rather effectively. By trading within your risk tolerance, you enhance the probability of achieving success in your trading endeavours. It allows you to make informed decisions that align with your comfort level, ultimately increasing your chances of reaching your financial goals.
#4 Set Your Risk/reward Ratio to a Minimum of 1:2
The RRR involves evaluating and comparing the distance between your entry point in a trade and the levels at which you set your stop-loss and take-profit orders. It is advisable for day traders as well as scalpers to aim for a minimum risk to reward ratio of 1:2. This means that for every unit of risk, you aim to achieve at least two units of reward.
On the other hand, traders who are either into swing or position trading should aim for a wider minimum RRR of 1:3. By adhering to an appropriate RRR, you align your trading strategy with your desired risk and reward levels, enhancing your chances of long-term success in the markets.
#5 Control Your Risk Per Trade
Before entering a trade, you should have your risk goal clear in mind. Your risk per trade should be calculated in percentage, ideally not exceeding 1% per trade. By implementing a sound risk-to-reward ratio (RRR), you can potentially aim for a 3% return while risking only 1% of your capital.
To illustrate the impact of different risk levels, let's consider three scenarios: 1%, 2%, and 10% risk per trade over a 30-trade losing streak, assuming an account balance of $100,000. The trader risking 10% per trade has experienced a significant loss, with their account balance decreasing by 95.3%. The trader risking 2% per trade is down 44.3%, while the trader risking 1% per trade has a more manageable loss of 25.2%.
This example highlights the importance of managing risk per trade. When a trader risks a higher percentage, it becomes increasingly difficult to recover from a series of losses. Although it's unlikely to have 30 consecutive losing trades, it's essential to be prepared for losing streaks, as they can occur at some point in every trader's journey. Protecting your capital from significant losses ensures that you have the ability to rebuild and continue trading successfully.
#6 Keep Your Risk Consistent
It's common for beginners to increase their position sizes when they start making profits, but this can be a dangerous practice that can lead to account losses. It's important to keep your risk consistent. Don't let overconfidence cloud your judgement and make you less cautious about risk. Just because you've had a few winning trades doesn't guarantee that the next one will be profitable. Avoid the temptation to become overconfident and deviate from your money and risk management rules without valid reasons.
#7 Understand and Control Leverage
Leverage allows you to trade with more money than your initial deposit. For providing you with the leverage, your broker will require you to set aside only a small portion of the total value of the position as collateral. Though getting access to leverage these days is extremely easy, it's important to remember that while leverage can amplify profits, it can also lead to bigger losses.
Being over-leveraged means that even a slight market change or a simple mistake can result in a disproportionately large loss. It's crucial to use leverage wisely and consider your risk tolerance and trading strategy when determining the appropriate level of leverage for your trades.
#8 Take Currency Correlations Into Consideration
Currencies are traded in pairs, which means they are interconnected or correlated to each other. As such, understanding forex correlations can assist you in effectively managing the exposure of your forex portfolio and reducing overall risks. Correlation refers to the measurement of how the price of one asset changes in relation to another. You can find currency correlation indicators for mt4 which will help you understand how two different currencies are correlated to each other.
Positive correlation indicates that two assets tend to move in the same direction. On the other hand, negative correlation means that they move in opposite directions. By being aware of currency correlations, you can make more informed trading decisions and better assess the potential impact of one currency's movements on another.
The tips mentioned above serve as a foundation for effective risk management. But you should know that the ability to follow these rules with discipline comes from your capacity to maintain control over your emotions. Make sure that you work on building strong trading psychology along with following the above-mentioned rules. This will be a great step towards your trading success.