What Is Risk Management In Forex Trading?

Before I answer the question, “What is risk management in Forex trading?” another critical question needs to be asked. Why is risk management necessary in the first place?

The answer is probably quite obvious, but it needs to be drilled into the minds of all Forex traders. When risk management is ignored, you can end up depleting your trading account so fast you could lose all the money in your trading account.

Risk Management

Risk management in Forex trading is a process that has many components. I’ll list them below and then go into each one in detail.

1. Reading Charts
2. News
3. Lot Size vs Account Size
4. Take Profit (TP) / Stop Loss (SL) Ratio
5. Maximum Loss Limit Per Trade
6. Maxium Total Loss Limit Per Per Day
7. Discipline & Emotion
8. Knowledge & Skills
9. Create A Successful Trading System

1 – Reading Charts

A chart shows the price changes between currency pairs at a specific moment in time. Note that all currencies are identified by three letters.

For example, USD is the US Dollar. EUR is the European Euro. JPY is the Japanese Yen. And the GBP is the US Great British Pound.

These four happen to be the most heavily traded currencies in the world listed in order of volume.

I shall be using the chart below to explain the basics of how to interpret the most important parts of this chart. I took this screenshot of the GBP-JPY Pair on January 18th, 2022.

The horizontal axis at the bottom represents the time period for the trade. This can range from a one-minute duration to a one-month duration. In the above example, I used a daily chart where the width of the bar represents one day.

The verticle axis on the right represents the exchange rate between the currency pairs represented by the numbers indicated. The first currency is called the Base Currency. The Second is the Quoted currency.

For example, in the GBP-JPY pair shown above, the GBP (British Pound) is the Base Currency. The JPY (Japanese Yen) is the Quoted Currency. Let’s pick a round number of 157. This means that one British Pound is trading for 157 Japanese Yen at that specific moment in time. This is not a static number as traders can make that go up and down. This can clearly be seen in the graph in the chart.

Candlesticks

In the above example, the type of bar is called a CANDLESTICK. It’s the wicks at the ends that influenced this name.

The total length of the candle and the wicks tell a story about how the currency pair moved as a result of the actions of traders.

Blue candles depict that the base currency, GBP fell that day with respect to the Yen. This happens when the Bearish traders are dominant over the bullish ones.

The opposite is true for the yellow candles. These show that the GBP rose in value with respect to the Yen.

Here are the details of the story for that specific hour. In bearish movements, the top of the candle represents the currency price at the start of the hour. The bottom of the candle represents the price at the end of that hour. The extreme ends that include the wicks represent the maximum and minimum price of the pair movement.

When candle movements are long, that indicates a lot of volatility. The bulls and the bears seemed to be having a party! Or a fight. When the lengths are small, that signifies the battle between the bulls and the bears was not as intense.

Five Main Outcomes From Reading The Charts

1. Predict what the short term and long term trends are in either direction, up or down
2. Estimate where and when the price movement will reach either a peak or a dip before turning around (Major Inflection Point)
3. Understand what a pull back is and how it differs from an inflection point and predict where and when it till occur
4. Identify areas of consolidation, meaning when the price action goes sideways (stagnation)
5. Use trend lines that will help to predict the above price movements

Reading charts is a skill that can be learned. You can use naked charts and base your predictions solely on price action. Or use indicators. Perhaps use a combination of both.

The above chart has examples of all the above 5 examples. See if you can detect them. I will be going into reading charts in more detail in a future article. Hence, I will not be going any further at the moment.

The goal of chart analysis is to help predict if you buy the pair, the price will go up. Or if you sell the pair, the price will go down.

Is this foolproof? Absolutely not. The better you become in developing these skills, the lower your risk will be in making trades. You will still have losses. But on average, you will come out ahead and become a successful trader.

There’s more to success than just reading the charts.

2 – News

It is critical before setting up your trades to be aware of any news events that will be taking place while your trades are open. For example, the Non-Farm results are announced on the 1st Friday of every month at 8:30 am EST.

This creates tremendous volatility in the charts for all currencies paired with the USD. Even those that are not can experience volatility to a lesser degree. The one-minute chart shows what happens in real-time. The candles I talked about above gyrate up and down within fractions of a second. And the excursions can be from 30 pips to even over 100 pips.

The above graphic is a snapshot of the economic calendar in the US for a specific day. Note the type of news as well as what time it will be delivered. Armed with this information you can use this to make better reading decisions. In a future article, I shall be going into more detail on what kind of news can affect the charts and how.

Consequences Of High Volitatility

When you set up trades to run for a few hours or even a day, you will lose control of the outcome. The candle gyrations will be so extreme, they could stop you out in a second.

If you’re lucky, your trades will be stopped out at a profit. What seems to be most likely is you will be stopped out at a loss.

What Action Should You Take To Minimize Risk?

This is not to say you can’t enter and exit trades during rapid candle movements. If you are prepared and have the adrenaline and fortitude, it is possible to enter and exit trades very fast and make profits in a very short period.

This is not for the faint-hearted. Until you train yourself to trade under these conditions, the better policy is to not place any trades before these kinds of news releases. Why risk it when you can wait for the news event to pass?

Every broker has a calendar of financial news events around the world that occur daily at specific times. Astute traders review these events to see what kind of impact they would have on their intended trades. When in doubt, don’t have any open trades that could be influenced by the specific news.

3 – Lot Size vs Account Size

How Is Lot Size Defined In Forex?

The following definition is based on currency pairs that include the US Dollar (USD).

• One Standard Lot is the equivalent to $100,000.00 represented by 1.00
• One Mini Lot is the equivelant to $10,000.00 is represented by 0.1 Lots
• One Micro Lot is the equivalent to $1,000.00 is represented by 0.01 Lots

Leverage In Trading

There is one factor that enables a forex trader to make a significant profit on small moves in the currency exchange rate. The factor I am referring to is leverage.

All brokers give traders leverage on their trading account. This can range from 50:1 to 400:1. Most brokers give a 200:1 leverage. That is what my broker allows.

Reccomended Trading Account Size For A Beginner

A 200:1 Leverage means that for every $1 you deposit into your trading account, you can place a trade worth up to $200. When you are a new trader it is best to limit your account between $1000 and $2000. Just imagine, a $1000 account will give you control of $200,000.00! (200 x 1000)

This can be exciting as well as frightening. This leverage enables you to make a significant profit as well as loss on small movements in the currency pair exchange rate.

Good risk management practices are designed to minimize losses when your trade goes against you.

Trading Risk Per Account SIze

For a $1000 account size it is prudent to limit each trade to a mico-lot or 0.01 lots. Every pip movement relates to approximately 10 cents.

If your trade gains 100 pips, your account increases by $10. Conversely, if your trade decreases by 100 pips, your account drops by $10.

You can learn more about pips in my previous Forex article called:

What Is A Pip In Forex Trading? How To Use It To Lower Risk!

By extrapolation, for a $10,000 account, limit your lot size to a mini lot, or 0.1 lots. Every pip movement is approximately $1. For $100,000 you will be able to afford trading in standard lots. So a movement in one pip is equivalent to a change in $10. Using the 100 pip analogy, this would be a profit of $1000 if your trade moved upwards. And a loss of $1000, if it moved downwards.

Note that in all the above account sizes, the 100 pip movement resulted in a 1% change in your account. We shall be using this metric in setting your stop loss levels to minimize risk when we talk about stop loss and take profit below.

4 – Take Profit (TP) / Stop Loss (SL) Ratio

This is where you can control the risk to reward ratio of your trade. As well as use the stop loss set to limit your loss exposure. It is always a good idea to set your SL before your TP. Once you do, I recommend using a 2:1 TP/SL ratio. A 3:1 or higher should only be used in the chart patterns showing there is a high probability the trade movement will reach this profit level in a reasonable amount of time.

As you get familiar with reading the charts, you will want to use the chart patterns to set your SL and TP. In later articles, I shall address this concept in relation to the charts.

5 – Maximum Loss Limit Per Trade

I was taught to set SL levels to not exceed more than a 2% loss per trade. For a $1000 account, the maximum loss should not be more than 2% ($20). I recommend, limiting this to 1% ($10).

When using a micro-lot per trade, a 1% loss limit dictates no more than a 100 pip movement from the trade entry point.

A buy trade means setting the SL 100 pips below that buy price. For a sell trade, the SL would be 100 pips above the selling price.

Once you’ve set your SL, your TP should be placed at a level of at least 200 pips. When you learn to read chart patterns, this is what you will use as a guide to set your SL and TP levels. Always use the maximum 1% loss to be your guiding light.

More volatile trading conditions will dictate when to use the 2% SL level. This will be covered in later articles.

6 – Maximum Total Loss Limit Per Day

When setting up individual trades, make sure that if every one of them is closed at a loss, the total loss will not be more than 5% of your trading account.

For a $1000 account, the total loss per day should not exceed 5% or $50. A $2000 account should not lose more than $100 per day.

What do you do if you are careless and end up losing more than 5%? I strongly suggest not trading for the next day. Instead, review your losing trades to see where you went astray.

In a future article, I shall go into the most common reasons you could experience a larger than normal loss. As well as ways to mitigate losing.

7 – Discipline & Emotion

It is very important to not let emotion enter into your decisions you make in managing trades. For example, never use your gut feelings to place a trade.

Always analyze the charts using the training you have been through to find out if the conditions are right to set up a trade based on lessons learned.

If the conditions are not right, step away and don’t trade. Discipline has to be used to take this action.

After you enter a trade, and you see it going against you, NEVER alter your stop-loss position. You must guard yourself against not being willing to accept a loss.

Why is it that most traders are willing to increase the amount of money they are willing to lose by lowering the SL level? Yet they exit a trade prematurely when it is making a profit?

8 – Knowledge & Skills

The more knowledge you acquire about trading and use that to develop your trading skills will arm prepare you to make better trading decisions. This can go a long way to keep emotions at bay.

However, it takes time to achieve these goals. That is a powerful reason not to start trading using real money. All brokers will allow you to open a demo account that you can use to make trades.

Treat this as if you were trading using real money. Use the same rules I stated above regarding maximum loss. This is the phase in which you will take the time to learn different methods of trading so that you can evolve your own trading style.

Your objective is to make more money than you lose.

9 – Trading System

This is how you will eventually create a trading system all your own where you can make consistent profits. The best way to measure your progress is in increments of 100 trades.

Keep meticulous records of every trade you make that includes the following information.

1. Lot Size
2. Entry Point
3. Stop Loss & Take Profit Levels
4. Time When Trade Endfed.
5. Cause For Trade Completion – Auto TP or SL triggers OR Manual trade close
6. Value Of Profit Or Loss
7. Date Of Trade

Beginners rarely complete 100 trades and make a profit. If you don’t please do not beat yourself over it. Start again fresh, and continue trading using the knowledge and skills you are building.

When you are able to consistently make 100 trades that end with a net profit, no matter how small, you will have your very own trading system. That profit will get bigger the more experience you get.

Recap & Conclusion

This article has given you an overview of the critical factors that control your risk. Managing risk effectively is a learned skill. You become good at it after learning about the process and making your own mistakes. We all do. Make sure you make most of your mistakes in your demo account and not in your cash trading account.

Risk Management is even more important than learning how to make winning trades. If you don’t manage risk effectively, you could lose all your capital.

An important factor in Risk Management is to eventually develop your own trading system based on your personality and style that generates a consistent profit.

Trading Forex is not for everyone. What makes it attractive to so many is the possibility of making a lot of money as you become a better trader. Trading Forex is definitely not a get-rich-quick scheme. No matter what anyone tells you.

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Cheers.

Edwin Bernard