Forex Risk Management 101 | Protect Your Trading Capital FX110
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Learn how to manage Risk In trading and how to preserve your capital.
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WHAT IS FOREX RISK MANAGEMENT?
Forex risk management comprises 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. Therefore, being able to manage the levels of risk to minimize loss, while maximizing gains, is a key skill for any trader to have.
How does a trader do this? Risk management can include establishing the correct position size, setting stop losses, and controlling emotions when entering and exiting positions. Implemented well, these measures can prove to be the difference between profitable trading and losing it all.
TOP 5 FUNDAMENTALS OF FOREX RISK MANAGEMENT
1. Appetite for Risk
Working out your appetite for risk is central to proper forex risk management. Traders should ask: How much am I willing to lose in a single trade? This is particularly important for the most volatile currency pairs, such as certain emerging market currencies. Also, liquidity in forex trading is a factor that affects risk management, as less liquid currency pairs may mean it is harder to enter and exit positions at the price you want.
If you don’t know how much you are comfortable with losing, your position size may end up too high, resulting in losses that may affect your ability to take on the next trade – or worse.
Let’s say 50% of your trades are winners. In the long term, mathematically you can expect to have runs of multiple losing trades in a row. Over a trading career of 10,000 trades, the odds suggest that you will face 13 sequential losses at some point. This underlines the importance of knowing your appetite for risk, as you need to be prepared, with sufficient money on your account, for when bad runs hit.
So how much should you risk? A good rule of thumb is to only risk between 1 and 3% of your account balance per trade. So, for example, if you have an account of $100,000, your risk amount would be $1,000-$3,000.
2. Position Size
Selecting the right position size, or the number of lots you take on a trade, is important as the right size will both protect your account and maximize opportunities. To select your position size, you need to work out your stop placement, determine your risk percentage and evaluate your pip cost and lot size. For more on how to do these things, click on the link above.
3. Stop Losses
Using stop loss orders – which are placed to close a trade when a specific price is reached – is another key concept to understand for effective risk management in forex trading. Knowing the point in advance at which you want to exit a position means you can prevent potentially significant losses. But where is this point? Broadly, it’s whatever point your initial trading idea is invalidated. For more detail on this concept, click on the ‘Using stop loss orders’ link above.
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