Forex: Risk Management

What is Forex Risk management?

Forex risk management is the practice of applying certain strategies to minimize the negative impact that comes with trading. ie: making a loss, which is inevitable. 

Also, forex risk management are the methods used to protect one’s trading account balance. If losses are inevitable, then applying risk management in forex trading is mandatory.

 

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Understanding Forex Risk management

Risk management is the section of a trading strategy that determines your risk reward ratio. In other words, it tells you how much you should risk to make a gain (profit). This is done by understanding what risk management is, so that you may properly apply the best risk management strategies that should be a part of your trading strategy to better protect your trading account.

Apart from being disciplined, and having knowledge of, a forex trading strategy is comprised of:

  • 25% Entry Reasons
  • 25% Exits Placements
  • 50% Risk management

 

Entry reasons

Entry reasons are the conditions that were fulfilled (met) that signify to either buy or sell. Example: Price action patterns, candlestick reversal pattern or a break and retest of market structure

 

Exit placements

This is the area (to be more specific, the price) at which your stop loss and take profit are placed. Example: take profit below resistance and stop loss below support.

Forex Risk Management
Exit placements

 

Risk management

Risk management is used to determines your lot size depending on your risk tolerance. Risk tolerance is how much you are willing to risk in terms of a percentage of your trading balance

NB: If you use flexible stop loss (stop loss that is not a fixed amount for every trade), then your entry could influence where to put your stop loss, as a result, determines how big it should be.

This goes to show that risk management carries the most weight in a trading strategy, as a result, it is the most important component that determines if a forex strategy is profitable or not.

All that said, your entries can be really good and your stop losses are at the best locations, but without risk management, your trading balance isn’t going anywhere but down.

Before going any further, I want to assure you that the information might seem a lot, but it’s not complicated to the point you’ll feel overwhelmed. With that said, let’s get into it.

 

How is risk management used in forex trading?

Traders apply forex risk management by paying close attention to several variables (components) that make up (or play a part of) their trading strategy. 

In some cases, these variables are also used to make up, or at least, influence another variable in their forex risk management strategy.

To dumb it down, a forex trading strategy is a number of variables that correlates with each other. Some variables are only used, for example, exits placements, while another variable is used for both exit placements, risk management, and/ or entry reasons.

 

How to create a Forex Risk management strategy?

To create a good forex risk management strategy, a trader must take into consideration the different variables that play a role in his trading strategy. As mentioned above, these variables correlate (work) with each other, and the better they do, the more consistent (profitable) a trading strategy is.

Of course, this means that if a strategy is not consistent, then a variable needs to be adjusted or be remove completely. 

So Before going any further you at least need to know what makes up a risk management strategy.

 

What makes a risk management strategy?

The key components that make up a good risk management strategy are:

  • Lot size
  • Stop loss
  • Pip value
  • Asset volatility
  • Currency correlation
  • Risk appetite
  • Leverage
  • Risk
  • Reward
  • Risk-Reward Ratio (RRR)
  • Place of Entry
  • Emotions

Lot size

When talking about risk management, the best way to describe lot size is the rate* at which your open trade will rise or fall in terms of profit. 

For example, a .01 lot size on EURUSD means each pip price move in or against your favor, your equity will adjust by $.10. (10 pips with .01 = $1.00) 

 

Stop loss

The size of your stop loss will equal the total amount of money you will lose if price is to go against you. As the curve shows below, the bigger your stop loss, the smaller your lot size should be. 

Forex Risk management
Bigger the lot size; Smaller the stop loss

These are influenced by your risk appetite.

 

Pip value

As explained in chapter 4: What is a PIP? the value of a pip differs depending on the quote currency of the pair you are trading. As such, while staying within the boundaries of your risk tolerance, a larger lot size may be used for currency pairs with low pips value such as the NZD pairs. (eg: AUDNZD)

Of course, this is taking the size of your stop loss into consideration.

Account BalanceStop loss (in pips)Risk toleranceQuote CurrencyPip ValueLot Size
$100505%NZD$5.02.02
$100505%USD$10.01.01

 

Asset volatility

Another variable in creating a risk management strategy is the volatility of a trading asset. Some trading assets are more volatile than some. In this case, volatility is referring to the distance in pips price moves at an average. 

Assuming you used fixed stop loss, then for high volatile currency pairs, like GBPUSD and GBPJPY, you would want to have a larger stop loss to avoid being stopped out unnecessarily, only for price to push in your direction shortly after. 

The same goes if a trader uses flexible stop loss. Assuming he place stop below/ above structure, then his stop loss will automatically be bigger.

As a reminder, the bigger your stop loss, then the smaller your lot size should be.

 

Currency correlation

Currency correlation is yet another topic that was vastly covered in an earlier chapter in this free online forex trading course. throughout that chapter, explantation on how currency correlation plays a role in risk management.

For example, assuming you are risking 5% per trade; buying (or selling) two strong positive correlated pairs at the same time means you are risking a total of 10%. This is because if either hit stop loss, the other will likely hit stop loss as well, thus doubling your loss.

 

Risk appetite (tolerance)

In forex, risk appetite and risk tolerance are two sides of the same coin. The only difference is how they are expressed.

Risk tolerance refers to the percentage of your account balance you are willing to risk per trade. (example 2% or 5%)

Risk appetite, however, classifies traders based on their risk tolerance as: (the values below are only for example purposes)

  • Conservative (eg: 1%-2%)
  • Moderate (3%-5%)
  • Aggressive (6%-8%
  • Moderately aggressive (9%-10%
  • Very aggressive (10% or above).

 

Leverage

Leverage is double edge sword that can grow or blow your account. Over-leveraging is an issue most traders face today, as a result, it is one of the leading causes why most forex traders fail. I suggest no more than a 1:500 leverage.

 

Risk

Risk and risk tolerance are very closely related. Risk tolerance can be (at the very least, should be) a fixed value expressed as a percentage (eg: 5%), while risk is a dynamic monetary value that changes with your account trading balance 

This explanation is under the assumption that a trader adjusts his/ her lot size according to his trading balance to maintain his risk tolerance.

 

Reward

Reward in forex trading is the same as risk, with the exception that one is positive (reward) while the other is negative (risk).

To put it differently, the risk is how much (in money) a trader is willing to lose, while the reward is how much he is trying to gain for that risk.

 

Risk-Reward Ratio (RRR)

A risk-reward ratio the quantitative relationship between the risk and the reward express as a ratio. In other words, how many times a reward (100) can be divided by the value of the risk (20).

Risk (in pips)Reward (in pips)Ratio
501001:2
251001:4
201001:5
101001:10
10501:5
10401:4
10301:3
10201:2

The values under the risk and reward columns are stop loss and take profit size in pips respectively.

In accordance with maintaining a good risk management strategy, the reward should always be at least two times (2x) bigger than your risk.

Risk ($) = Stop loss (pips) / Reward ($) = Take profit (pips)

To explain differently, to manage your risk when trading forex, your take profit should always be at least two times (2x) the size of your stop loss. Doing this will give room for losses while remaining profitable. 

For a better explanation and examples, take a look at the forex risk management excel spreadsheet chart below.

Forex Risk management chart

Risk Reward$ Per Win$ Per LossTotal WinsTotal LossTotal tradesAccuracyTotal Gains
1:1+$10-$10641060%$20
1:2+$20-$10551050%$50
1:4+$40-$10461040%$100
Turn phone to see full table

 

Place of Entry

Carefully considering your place of entry could help you manage your risk when trading forex. To illustrate what I mean, please take a look at the pictures below.

Forex risk Management
BAD place of entry

As you can see, the area where I’m looking to enter a trade is far above my designated stop loss area, which is below the previous higher high. 

Assuming I enter with proper risk management in mind, the size of my stop loss will determine the size of my lot size and take profit,

which ought to be at least 2x the size of your stop loss.

Forex Risk Management
GOOD place of entry

In this scenario, I looking for an entry right at the retest of a previous lower low which is acting as a resistance. As you can see, the previous lower high is not too far from my entry, thus enabling me to put a smaller stop loss, with a bigger lot size; additionally, a bigger risk-reward ratio.

 

Emotions

Emotions are a big problem for forex traders because they can lead a trader in closing and entering trades that shouldn’t.

How emotions affect risk management in forex trading
  • Greed causes a trader to over trade
  • Fear causes a trader to avoid entering a trade despite the valid entry signal
  • Anger causes a trader to cast risk management aside.
  • Doubt causes a trader to have lack of confidence in his technical analysis and/ or trading strategy

 

How much risk should be used in forex trading?

Risk tolerance is where most traders find their individualism. This is because everyone has a different risk tolerance. Professional traders recommend risking no more than 2% of your trading balance, however, to make a decent earning from a trading account that is less than $1000, the risk would have to be higher, especially if forex trading is your main source of income.

Speaking from experience, 5% of your trading balance should be the maximum you risk on any given trade.

 

How to Calculate Risk in Forex Step by Step

Calculate your risk using the forex risk calculator provided below.

  • Step 1. Choose your account base currency

This is the account currency that you deposit, trade, and withdraw in.

  • Step 2. Choose the trading asset (currency pair) you are planning to trade
  • Step 3. Enter your current account balance
  • Step 4. Enter the stop loss size that you wish to use.
  • Step 5. Enter your risk tolerance (%)

 

Top 17 risk management strategies in forex trading

  1. Adjust your lotsize once (at the start of the week)
  2. Adjust your lotsize based on your trading balance
  3. Withdraw half of your weekly profit
  4. Set and Forget
  5. Only enter at structures
  6. Trade with the daily trend
  7. Enter on smaller timeframes
  8. ALWAYS use a stop loss
  9. Take profit should at least be 2x Stop loss
  10. Use multiple take profits
  11. Plan your trades carefully
  12. Stay within your risk tolerance
  13. Anything uncertain is not worth entering
  14. Never add more trades to a losing one
  15. Smaller risk reward ratio for countertrend trades
  16. Avoid entering trades less than 50 pips away from structure
  17. Never increase nor remove your stop

 

How can you avoid risk in forex trading?

Since forex is all about risk; a game of probability, then there is no certainty in forex trading, as such, you cannot completely avoid risk while trading forex. While you may not be able to completely avoid the risk that comes with trading, you can mitigate the risk by applying the list of risk management strategies for beginners explained below:

 

1. Adjust your lotsize once (at the start of the week)

This is one of the most common mistakes done by new traders and even old traders without evening knowing what they are doing wrong. Avoid tampering with your lot size throughout the week. This is because you are putting your account at risk each time you do it while lessening the chance of recovering the loss.

For instance, after a winning streak, you decide to double (or triple) your lot size, and that one trade with the biggest lot size ends up being your only loss. This could wipe away all your hard earn profit and even more. To maintain your risk tolerance, you are now forced to reduce your lot size, which closed in profit. Of course, this would not completely recover all your lost earnings.

With that in mind, it’s best to adjust your lot size at the start of the week (before your first trade) and maintain that lot size throughout.

 

2. Adjust your lotsize based on your trading balance

Account balance and your lot size work hand in hand (like yin and yang). Depending on your account balance at the starting of the week, whether increase or decrease, adjust your lot size accordingly to the balance of your trading account to maintain your risk tolerance.

 

3. Withdraw half of your weekly profit

The less you withdraw, the more you can earn, but you need money to support yourself. My recommendation on how much and how often you should withdraw from your trading account balance is half of your earnings (profit) either once every week, every two weeks, or monthly. For example, look at the table below

Initial Deposit = $200
Turn phone to see full table

WeeksStart Of Week Balance (EoW profit + Starting Balance)End of Week (EoW) ProfitWithdrawal (half of the previous week profit)
1$200$100
2$300$150$50
3$450$225$75
4$625$337.5$112.5
5$1012.5$506.25$168.25
61318.75$759.38$379.65

 

4. Set and Forget

As the title suggests, you set a trade and then you find something to occupy your time and mind. This will avoid you from constantly looking at your running trades. Looking at your trades constantly can incite doubts as price is seemingly moving towards your stop loss. The fear of losing too much money will convince you that it’s better to manually close that trade in a loss before it touches stop loss.

Shortly after doing so, price reverse and blew pass your take profit, leaving you filled with regrets.

 

5. Only enter at structures

You can reduce your risk of being stopped out while increasing your chance of being profitable by selling resistance and buying at support.

 

6. Trade with the daily trend

Chapter 19: “How to do technical analysis”, of this online forex trading course, explains why trading the daily trend can increase your consistency and probability by at least 10%.

 

7. Enter on smaller timeframes

Again referring to chapter 19, which also shows how to do top-down analysis explains that smaller timeframes are best for entry to avoid drawdown.

 

8. ALWAYS use a stop loss

If you know a trader that trades without stop loss or speaks ill about using stop loss, then do yourself a favor and stay away from that person. Stop loss is a must for every trade that you enter. In fact, you should establish where your stop loss is going to be before placing the trade.

 

9. Take profit should at least be 2x Stop loss

As explained above, the bigger the risk reward ratio is, the better.

 

10. Use multiple take profits

Using multiple take profits (targets) is one of the best strategies to minimize risk in forex trading. This is breaking your lot size into multiple individuals trades with smaller lot sizes, with each targeting different take profit levels.

For example, if you are used to using a single .10 mini lot on every trade, but is not certain that price is going to go all the way to your 100 pip take profit for your next trade, then break down your lot size into three (at least 2) trades with smaller lot size targeting different take profit levels to secure profit.

TP 1 (25 pips)TP 2 (50 pips)TP 3 (100 pips)
.06.03.01
.08.04.02

By observing, you can notice the largest take profit has the smallest lot size. Vise versa, the smallest the take profit have the largest lot size.

In doing so, if price goes even +25 pips in your direction, more than half of your lot size will be closed thus securing some profit. If either or both of the other trades were to reverse and hit your stop loss, the loss would be severely minimized as you’ve already closed most of your lot size.

If you wish to use a multiple take profit strategy to minimize risk in trading the forex market, then I suggest using the lot size table below as a guide.

telegram forex signal
Appropriate Lot size per account balance

While on that note, these are the exact strategies, (trading in the daily trend, multiple TP, etc) used by Rhasfx Forex Signals which bore a very high win accuracy as a result.

PLEASE NOTE: The signal service is currently on hiatus due to technical reasons. But you can join our forum for news updates regarding it.

11. Plan your trades carefully

Be sure to always plan your every trade. You can plan your trade(s) by doing technical analysis (preferably over the weekend). This enables you to stay ahead of the market give you a winning edge.

 

12. Stay within your risk tolerance

If you know you are within your risk tolerance, then the thought of losing one trade should not affect much, if at all. Only when you are risking too much is when you are compelled to always be looking at your trades. As mentioned earlier, this could lead to doubts, which could lead to premature closure of running trades.

 

13. Anything uncertain is not worth entering

The forex market has been around long before any of us were born and it will be hereafter we’re gone. As such, there’s no need to force any trades. By forcing I mean, entering a trade that is not clear on the intended direction it’s going. 

This is due to your technical analysis not giving a clear indication of which direction has the higher probability of price going. This does not automatically mean you are doing something wrong, this is just part of forex, the market does this a lot of the time.

When in a scenario such as this, it is best to avoid entering any trade until another high probability trading opportunity comes by.

 

14. Never add more trades to a losing one

If you have a running trade that is currently in drawdown, never open another trade until that running trade is in profit. Adding more trades to trade(s) that are in drawdown is only using more of your equity, thus increasing the possibility of being forcefully stopped out by your forex broker. (ie: closing all running trades because you no longer have enough margin to maintain the open trades)

 

15. Smaller risk reward ratio for countertrend trades

Referring to chapter 20: Primary and Secondary trends, trading secondary trends should have a smaller risk reward ratio compared to those used when trading the primary trends.

 

16. Avoid entering trades less than 50 pips away from structure

This brings us back to the importance of planning your trade. Avoid entering trade a trade that is less than 50 pips away from a structure, especially if it’s the first time price is approaching that structure in a long while.

 

17. Never increase nor remove your stop

Once you set your stop at the appropriate location, then what’s the point of removing or increasing it? (New) traders do this all the time because they convinced themselves that price is only in a retracement and will go in their favor. They hold on to the trade only to realize that price had changed the trend, unfortunately for them, by the time reality hits, that trade is now running deep into drawdown, taking almost half of their trading account with it.

 

How to apply forex risk management

At this point in the chapter, you probably think that applying forex risk management is easier than you thought. The truth is, you are correct but you are also wrong. Applying risk management in forex is easy when you think about it, but the reality of the matter is that improper risk management is the leading #1 cause of what most traders fail (blow their trading account).

 

Why most forex traders lose their money?

More than 90% of forex traders lose their money because they forget, in most cases, purposely neglect one or more variables that make up the framework of how to apply risk management in forex.

I’m positive that you’ve seen at the very least a picture or video (mostly in the form of a meme) of someone entering at the wrong place at the wrong time. Right after they enter price reverse, only for them to keep stocking more and more trades with the hope that price will reverse in their direction.

Tradingmeme
Risk management meme

That’s an example of neglecting the place of entry, lot size, and stop loss while incorporating too much emotions.

 

Why is Risk management important in forex?

Risk management is (at the very least, should be) the core of any (manual) day trading strategy. This goes without saying that if you are an intra-day trader, then risk management is even more important to you than any other type of trader.

Scalpers enter and exit the market very quickly so they don’t need to use take profit and/ or stop loss. Swing traders and position (investors) traders enter a trade only to leave it running for days to weeks, so their risk-reward ratio is often very high.

Risk management is important because it can make or break a trader depending on how properly it was applied. The importance of risk management doesn’t stop at the profitability of a trading strategy, it also helps with a trader’s discipline, which is very important in becoming a successful trader.

For additional information about forex risk management, please visit dailyfx.com

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