Risk Management in Forex Trading Articles | Risk Management

By: Ahmad A Hassam

Many currency traders find it hard to follow simple risk management rules. Many times, they will turn winning positions into losing ones. They will be surprised to find solid trading strategies result in losses instead of profit.

Regardless of how knowledgeable and intelligent a trader maybe about the markets, their own psychology and emotions will cause them to lose money. What can be the cause? Are the markets so enigmatic that only a few succeed in making profit?

The most likely main cause is that many currency traders commit the same common mistakes. However, the good news is that these mistakes while they can be emotionally and psychologically challenging, can be solved.

Most forex traders lose money. They fail to understand and apply proper risk management rules in their trading. Risk management means knowing how much you are willing to risk and also knowing how much you are looking to gain in a trade.

Without a sense of risk management, many traders hold onto a losing position for an extremely long amount of time and take profit on a winning position far too prematurely. The net result is that traders end up with more winning positions than losing ones but their account Profit/Loss (P/L) is negative. Keep these simple risk management rules in mind while trading.

Risk-reward ratio is very important for you to know and understand. As a trader you should calculate a risk-reward ratio for every trade that you make. In more simple words, you should have an idea of how much you are willing to lose if the trade goes against you. You should also know how much you are expecting to make in a trade. A general rule of thumb that you should apply is that your risk-reward ratio should not be less than 1/2. With a solid risk-reward ratio, you can eliminate a trade that is not worth the risk by not entering it.

Use stop loss orders to specify the maximum loss that you are willing to accept. Using stop loss helps you avoid the scenario where you have many winning trades but a single loss large enough to wipe out all your profits. Using trailing stops can be good.

There are two ways to place the stop loss order.
1) Initially place the stop loss at a reasonable level.
2) Trail the stop meaning move it forward towards profitability as the trade progresses.

There are two recommended ways of placing the stop loss order. One involves placing the stop loss order 10 pips below the two days low of the currency pair. For example, if the EUR/USD recent low was 1.1300 and the previous day low was 1.1200, then place the stop loss at 1.1190, 10 pips below the two day low if you want to go long.

Another volatility based method is to use the Parabolic SAR indicator. It displays a small dot at the point on the chart where you should place the stop loss. Parabolic SAR is a volatility based indicator. You can find it on the charting software provided freely by your broker.