Risk Management in Forex Trading
There are several components to successful trading. You need to acquaint yourself with your strengths and weaknesses, be realistic about how much you can actually invest, and know when to take your chips off the table when you are successful. Lastly, you need to know when to stop and admit that you are wrong. Part of forex trading is understanding that sometimes, you will be wrong and will have losing trades.
A good forex trading strategy is one in which your aim for profits is balanced by your awareness of risk. To ensure a successful trading strategy, you need to have a sound risk management forex trading system.
What is Risk Management?
There are several forms of risk management. They are categorized into the areas that can impact your trading. In forex trading, there is price risk management, which describes the risk associated with your position based on the movement of the exchange rate. There is also credit risk. This risk is your exposure to a sovereign government and their willingness to defend their currency.
Some sovereign governments use their money to manipulate their economy and artificially increase or decrease its value relative to other currencies to benefit the nation. If you are trading share prices, there is also operational risk. Investors are exposed to a change in the management of a company or the removal of a board of directors. There is also systemic risk. This risk reflects what happens to a market if “all hell breaks loose,” like a pandemic.
What is Exchange Rate Risk Management?
Exchange rate risk management is similar to price risk management, but your exposure is to the returns of a currency pair. You can measure your price risk management using several tools. For example, you might want to know how much you will make or lose for every big figure move in a currency pair. You could also determine how much you will make or lose for every 1% change in the currency pair. Understanding your loss or gain based on these movements can help you create a risk management plan for your forex trading.
What is a Forex Exchange Rate Risk Management Plan?
Before entering any trade, you want to make sure that you have a risk management plan to handle your transactions. While each transaction might have a different risk design, the concepts should be similar. Here is an example. Before you enter a trade, you should determine where you will enter, where you will stop loss and where you plan to take profits.
You can use several techniques to determine your entry and exit price. Your exit price could be based on a percent loss, a dollar (or your base currency) loss, or a loss based on market levels. For example, you might decide that you want to enter a USD/JPY trade at 122.85. Your stop loss could be right below the 10-day moving average at 122.35. Your take profit level could be the March highs at 125.06. In this trade, you would be risking 0.50 to make 2.15. The profit factor, which is the amount of potential gain divided by the possible loss, is 4.3. Any profit factor above one will allow you to lose more than you earn. Alternatively, you might determine that you are willing to lose a 1-big figure to make 2-big figures or willing to earn 2% to lose 1% possibly.
The Math Behind Risk
Your strategy will help define your risk management. For example, if you have a scalping trading strategy where you are consistently looking for small gains, the goal might be to gain more than you lose. If you are successful 66% of the time and lose 33% of the time, on 9 trades each risking $100, you could earn $300 ($600-$300).
Alternatively, if you have a trend-following strategy, you might lose more than you earn, but your gains on your successes can be more significant than the losses on your losing trades. If you were successful 33% of the time but earned $300 on successful trades and lost $100 on losing trades, you would generate profits on nine trades and produce a profit of $300 ($900-$600). Since the goal is to create an effective strategy, you need to tailor your risk management strategy to the type of forex trading strategy you plan to employ.
The Bottom Line
The upshot is that you want to have a risk management strategy tailored to the type of trading strategy you plan to employ. There are several types of risk management, but for forex trading, the most pertinent is price risk management. You want to make sure you have a profit factor above 1, which will provide you with flexibility on trades. Before entering a transaction, make sure you have your risk management strategy worked out.
