Are you eager to trade foreign currency pairs? Are you a gambler looking for the latest exciting form of online gambling, or are you a speculator dedicated to forecasting outcomes in a logical, disciplined fashion? Casualty rates for the former are incredibly high, but speculators know the value of risk management tools and how to apply them in the forex market. Those individuals have a greater probability of succeeding and becoming veteran forex traders.
The forex market is known for violent swings and changes in direction, often due to volatility and adjusting to market events. Awareness provided by an effective event calendar can prevent being blindsided, but how do you protect against downside risk without having to stay glued to your monitor “24X7”? There are several tools that are part of your broker’s offering that can help you in this area, as well as well-defined risk management processes and indicators.
A few tasks can also be described as personal initiatives since they require action on your part and an assessment of your preferred trading style. Do you consider yourself aggressive or conservative in how you approach forex trading? Your determination will affect the size of your positions, your risk/reward analysis, where you might place a stop-loss order, and where you might take your profit. Your choice of trading pair, when you trade, and how much leverage you put in play can also impact your risk profile.
Veterans learned early on in their careers that risk management processes help them overcome the bad patches that every trader encounters. If you review their journals, they are comprised of several small gains and losses, but the few major winning trades put them over the top. Unprepared beginners often cut winners too early and have significant losses in their journals, especially when they removed stop-loss orders hoping the market would reverse.
In this article, we will expand on these topics, but the subject of forex risk management tools is broad. You will learn the major points involved, but it is highly recommended that you study this topic in more detail and then practice applying these principles in your practice sessions on a demo system. Take the time to learn about stop-loss and take-profit orders, how to compute a risk/reward ratio, how to size a position in the market, and what risk management indicators can also help protect you against downside risk.
Stop Loss and Take Profit Orders
What are Stop-Loss and Take-Profit orders? These orders are designed to automatically close an open position in the market based on the criteria specified by you. Most trading platforms allow you to set places for each of these orders when you prepare your pending order to enter the market. To protect your downside on a trade, you may set a Stop-Loss below your entry point if you are going long and the opposite if going short.
If the market reverses and triggers your stop, your position will be closed for a loss, in keeping with the principle of minimising potential losses. In chaotic markets, or when the market gaps after a weekend, a stop-loss may not be triggered. Check the terms in your broker’s agreement for details and to see if the broker offers a guaranteed stop-loss for a fee or Negative Balance Protection. Be sure to understand when stop-losses may be ineffective.
Take-Profit orders operate similarly. You may set them when initially preparing your pending order or amend the open trade once it is in the market. Setting the placement of this order will generally be part of your risk/reward ratio determination, which will be discussed in the following section. Many brokers also offer what is called a Trailing-Stop. This order will move automatically as your trade evolves. It is a way to protect your profits when a trend is in progress and, when triggered, will also close your position for a gain.
How far away from your entry point do you place a stop-loss order? There are several methods for determining this calculation. An Average True Range (ATR) indicator can tell you how much the market has been moving per time period as a guide. Just below or above-established support or resistance is another way to set placement, and other assorted tools can also guide you. The caveat is to place it far enough away from the action to provide protection but not too close, or it might be scooped up when normal agitations occur in the market.
Risk-Reward Ratio
Your initial task in trading is selecting a setup with positive profit probabilities. To be a consistent trader, you must sustain a win/loss ratio that meets your expectations, and one way of achieving this goal is through using a risk/reward ratio applied to every trade. If you latch onto a strong trend, you may always let your winner run, but most of the time, you will want to minimise your loss or take your profit and run.
Simply stated, a risk/reward ratio of “1:3” implies that the trader hopes to win three times as much for every dollar invested. How does this help a trader? The risk component equates to the size of the stop-loss. If the stop is set at 30 pips, then we expect to take profit at 90 pips. Stated another way, we need one winning trade to offset three losing ones to break even. Under this logical framework, if we have a 50%-win rate, then we would net after ten trades a total of 300 pips (5 X 90 – 5 X 30), excluding the impact of spreads and trading fees.
Studies have shown that conservative and beginning traders would be more successful if they employed a “1:2” ratio. These traders tend to close winning trades too early and let losing trades run too long before cutting them off. Once these tendencies become a thing of the past with experience, it may be beneficial to use a more aggressive “1:3” ratio. The takeaway is to find setups with positive expectations and then apply your ratios religiously for consistent results.
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Position Sizing
Veterans claim that position sizing is one of the most important aspects of forex trading. It can be confusing at first, but once you understand the logic behind the calculations and what various lot sizes mean, you will be equipped to handle the maths.
First, here is something about lots. A standard lot is 100,000 units of a currency. A “mini” is one-tenth of that or 10,000, and a “micro” is one-tenth of a “mini” or 1,000 units. For a single lot, 1 pip corresponds to $10. An acceptable loss rate on your capital balance can range from 1% to 3%. Professionals use 1% but may have a higher risk/reward ratio.
For now, let’s assume you have $5,000 in your account. You only want to risk 1% or $50 per trade. If your stop-loss is 25 pips, your pip/risk ratio is $2 per pip. The formula then is:
Position in Lots = Amount at Risk / (pips at risk X pip value per lot) = $50 / (25 X $10) = 0.2 lots
The result is 0.2 lots or two mini lots. Your use of leverage will dictate your actual financial outlay.
Risk Management Indicators
Do you have to be a maths genius to use risk management tools? The answer is, of course not. Practising with these rules for a while on a demo system will bring familiarity with their use, and several standard indicators on MT4 and other platforms can help guide you in your efforts. A few are as follows:
- Average True Range (ATR): this indicator will track the average price swings over several periods and hint at how far to place your stop-loss from your entry point.
- Bollinger Bands: the outer bands are two standard deviations away from the simple moving average and can be a dynamic guide of how far the market can swing in a given moment.
- Fibonacci Ratio Lines: draw these from a previous trend to find the projected levels for resistance and support in the future. Traders and robots alike use these levels as standard places to take profit or establish entry.
If you are willing to experiment, some vendors sell an app that will place a box-inlay on your screen to perform the necessary calculations. There are even free apps on the Internet where you can enter data for position sizing, among other things. Once you become accustomed to the process, you will not need these simplistic tools.
Concluding Remarks
Risk management tools are your best friends when trying to protect your account balance from downside risk and keep you in the trading game over the long haul. Further study and practice is advisable until these principles become part of your daily trading routine.