Risk Management Basics

Risk management can make the difference between your survival or sudden death with forex trading. You can have the best trading system in the world and still fail without proper risk management.

Risk management is a combination of multiple ideas to control your trading risk. It can be limiting your trade lot size, hedging, trading only during certain hours or days, or knowing when to take losses.

Why is risk management important?

Risk management is one of the most key concepts to surviving as a forex trader. It is an easy concept to grasp for traders, but more difficult to actually apply. Brokers in the industry like to talk about the benefits of using leverage and keep the focus off of the drawbacks. This causes traders to come to the trading platform with the mind set that they should be taking large risk and aim for the big bucks. It seems all too easy for those that have done it with a demo account, but once real money and emotions come in, things change. This is where true risk management is important.

Controlling losses

One form of risk management is controlling your losses. Know when to cut your losses on a trade. You can use a hard stop or a mental stop. A hard stop is when you set your stop loss at a certain level as you initiate your trade. A mental stop is when you set a limit to how much pressure or drawdown you will take for the trade. Figuring out where to set your stop loss is a science all to itself, but the main thing is, it has to be in a way that reasonably limits your risk on a trade and makes good sense to you. Once your stop loss is set in your head, or on your trading platform, stick with it. It is easy to fall into the trap of moving your stop loss farther and farther out. If you do this, you are not cutting your losses effectively and it will ruin you in the end.

Using correct lot sizes

Broker’s advertising would have you think that it’s feasible to open an account with $300 and use 200:1 leverage to open mini lot trades of $10,000 dollars and double your money in one trade. Nothing could be further from the truth. There is no magic formula that will be exact when it comes to figuring out your lot size, but in the beginning, smaller is better. Each trader will have their own tolerance level for risk. The best rule of thumb is to be as conservative as you can. Not everyone has $5,000 to open an account with, but it is important to understand the risk of using larger lots with a small account balance. Keeping a smaller lot size will allow you to stay flexible and manage your trades with logic rather than emotions.

Tracking overall exposure

While using reduced lot size is a good thing, it will not help you very much if you open too many lots. It is also important to understand correlations between currency pairs. For example if you go short on EUR/USD and long on USD/CHF, you are exposed two times to the USD and in the same direction. It equates to being long 2 lots of USD. If the USD goes down, you have a double dose of pain. Keeping your overall exposure limited will reduce your risk and keep you in the game for the long haul.

The bottom line

Risk management is all about keeping your risk under control. The more controlled your risk is, the more flexible you can be when you need to be. Forex trading is about opportunity. Traders need to be able to act when those opportunities arise. By limiting your risk, you insure that you will be able to continue to trade when things do not go as planned and you will always be ready. Using proper risk management can be the difference between becoming a forex professional, or being a quick blip on the chart.

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