Knowing when to take the plunge: How to spot and manage risk before making a trade
There are few topics that instil as much interest and anxiety in forex traders as risk management.
Despite being one of the most important elements of a trading strategy, risk management is still quite common for forex trading strategists to avoid talking about it.
There is a fundamental tension when it comes to risk management, however, as although logic dictates that we should do everything in our power as traders to minimise our risk exposure when making trades, we are also inclined to want to make as much profit as possible when it comes to executing our trades.
In fact, the lure of profit is more than likely what got us started forex trading in the first place!
In light of all this, it scarcely needs to be repeated that risk management and using the safest forex brokers out there is incredibly important and should form the basis of any trading strategy.
The reason why so many forex traders lose money or burn out relatively soon into their forex trading career is simply a lack of understanding about what ‘risk’ actually is and how to use this understanding of risk in formulating a trading strategy.
With that said, in this short article, we will give you a brief overview of what ‘risk’ is when it comes to forex trading, and how to create a forex trading strategy that properly manages the existence of these risks.
Doing so will not only ensure that you have a well-thought-out forex trading strategy but will also increase your chances of profitability in the long run.
What is risk and why does it matter? Understanding the different types of risk in forex
Given the centrality of currency to all kinds of commercial transactions, it is no surprise that the forex market is the biggest financial market that is actively traded each day. As the largest financial market, with a total global daily trading volume of around $5.1tn, it is also one of the most liquid.
Being ‘liquid’ means that it is readily available to trade with a high level of demand on the open markets. This means that it is relatively easy to buy and sell currencies on the open market.
High liquidity, however, always brings with it a lot of risk. It is the liquidity of the forex market that makes it so risky at times, as this means that prices will fluctuate a lot over the course of the day.
However, the risk associated with liquidity and price fluctuations is only one type of risk. There are also other types of risk that you face as a day trader – for example:
- Market risk:The level of risk in an individual market – for example, the US dollar market, the Euro market, or the pound sterling. This will be influenced by political, social and economic factors.
- Leverage risk: If you are trading on leverage to open trades, this will have a specific type of risk associated with it.
- Interest rate risk:The interest rates on currency loans set by central banks will control the supply of available currency in a given market. These change frequently and, as a result, have a level of risk associated with them.
Being able to understand the different types of risk and how they might affect you in their own ways is an important aspect of managing risk in your own forex trading strategy.
How can I manage the different types of risk?
As we can see, there are a number of different types of risk you must face and adapt to as a forex trader. Being able to identify these is the first step to properly managing them. What are some specific strategies or techniques we can adopt to do this?
- Stop loss orders: Using a stop loss order – i.e. an order to close a trading position once a threshold is reached – allows you to manage your risk by setting in advance your loss threshold on a certain trade. This protects you from sudden fluctuations when the market changes.
- Take profit orders:Just like stop loss orders act when you have absorbed a certain amount of loss, take profit orders act to operate when you have gained a certain amount of profit. This allows you to protect your profits before the markets turn against you.
- Know your risk threshold: Before setting any stop loss or take profit orders, you need to have a good sense of both what your risk exposure is, and how much risk you can afford to absorb if things go bad.
- Go easy on the leverage: While leverage trading is a good way to maximise your potential profit, it can also leave you heavily exposed to risk. Make sure that you don’t over-rely or over-expose yourself by relying too heavily on leverage.