Understanding risk management

A trader can’t control the price movements and can’t be 100% sure for the results of his/her trade, which is why Risk management a key element of Forex trading. Foreign Exchange Risk Management primarily tries to mitigate the risk arising from the value changing due to changes in currency exchange rates. As they say, “risk comes from not knowing what you’re doing” – Warren Buffett

By definition, risk management is the identification, analysis, assessment, control, and avoidance, minimisation, or elimination of unacceptable risks. It’s the ever-present risk of a bad trade that is closed with a loss.

However, it’s possible to control many other things: when to trade and when not to trade, what to trade, when to exit a trade, how big a position to open.

When you open an order, you can know the worst-case scenario if you have safety mechanisms in place. For example, if you have a Stop Loss order, you know that your maximal loss on this trade won’t exceed the size of the Stop Loss. It means that you shouldn’t worry about losing and can concentrate on the winning.

Be a controlled trader

Reckless trading – We distinguish two approaches to Forex trading: a reckless trading and a controlled one. A reckless trader has no systematic approach and doesn’t use Stop Loss orders. Such trader puts at stake the money he/she can’t afford to lose. As a result, this trader is under constant stress – something that drives him/her to ill-judged decisions.   

Controlled Trading – Controlled trader, on the other hand, has a trading system that fits his/her personality. He/she uses the rules of risk management and trades with spare money. Such trader is an active learner, psychologically stable and, consequently, will be able to stay in the market for a long time becoming a professional.

In addition, note that the bigger loss your account suffers, the harder it will be to recover your capital to the starting position. For example, if you had $100 and lost $50 (50% of your capital), you’ll need to increase the $50 have by 100% to get your account back to $100. The conclusion is that it’s necessary to be cautious and not to let your losses run.

The importance of position sizing

It’s very important to choose your position size wisely. Here’s the golden rule of experienced traders: risk no more than 1-2% of deposit for 1 trade.

Risk-reward ratio
A risk/reward ratio is the amount of profit you plan to get on a position relative to what you are risking in case of a loss. To put it simply, if your Stop Loss equals to 10 pips and your Take Profit is 50 points, your risk/reward ratio is 1:5.

Follow a plan

A trading plan is a very individual thing: every trader needs a personalized trading plan. Such a plan should include your personal expectations, risk management rules, and trading system(s). As Benjamin Franklin (or maybe someone else said), “by failing to plan, you are planning to fail”.

Find structured beginners content on EFX to help you build a plan suited to your circumstances. We offer 100s of resources free to traders. Contact one of our EFX specialists 24/7 on live chat or send us an email at info@efxsociety.com

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