Key Risk Management Principles for Forex Trading

Many novice forex traders begin trading without a trading plan, and this is one of the primary reasons why the vast majority of new traders lose money. Even with a trading plan, if the plan lacks a good forex risk management component, regardless of how well the plan may work initially, a trader can eventually lose everything.

The sections below cover some of the primary risk management concepts that traders can consider incorporating into their trading plans.

Read more: Forex trading money management strategy

Position Sizing

The first consideration for an effective forex risk management strategy involves what is known as “position sizing.” As the name implies, position sizing consists of determining what size of position you are going to take on a particular trade when an opportunity presents itself.

Furthermore, position sizing can be performed in a number of ways that range from the simple to the decidedly complex. For example, some traders size trading positions by determining how much risk they are willing to take on any given position in relation to the total value of the portfolio.

Others might take a more simplistic approach and just trade a certain lot size. They might pursue this strategy until this set trading size clearly becomes too large or too small for their portfolio, which usually depends, at least in part, on their overall trading success.

Still other forex traders might size positions depending on how profitable they think a trade might potentially be. For instance, they might put on a larger trade than normal when they feel that the probability of success of that trade is higher than normal.

Alternatively, a trader might downsize a particular trading opportunity, or even eliminate it completely from consideration, if its risk to reward ratio is too unattractively high. Basically, they would be avoiding risking too much in order to make too little. Read more on using the risk reward ratio for determining position size.

Read more on position sizing.

Limiting Losses

The second key forex risk management consideration has to do with managing trading risk once a position has been initiated. Most traders use stop loss orders placed immediately after initiating a position as an effective way of limiting risk that might arises from trading losses.

Some traders prefer to watch their positions instead of entering stop loss orders in order to avoid being whipsawed or having brokers shoot for and trigger their stops.

Nevertheless, this latter strategy can lead to a loss of discipline that can result in even worse losses than would otherwise have been seen. As a result, it would probably only be appropriate for more experienced and highly disciplined forex traders who are trading larger amounts.

Using Trailing Stops to Protect Profits

While managing losses is paramount to a forex trader, another key way to keep trading risk at manageable levels consists of recognizing when a profitable trade has run its course.

This third forex risk management concept involves using a trailing stop to protect profits as a position moves in the desired direction. Many traders make an initial move of their stop to breakeven once a hundred pips or so have been achieved.

Moving the stop even further toward the present spot rate will further protect gains once a trade becomes even more profitable.

In addition, trailing stops allow you to follow trends as they unfold for maximum profitability instead.

When a profitable trade has run its course – perhaps by observing a set of mutually confirming technical indicators that point to a market reversal – an efficient trader needs to close out the position.

More on take profit orders

Take profit orders will generally be set to close out some or all of the trader’s existing position at a better rate than is currently available in the market.

Take profit orders sell are usually executed when the market is bid at their level in the amount required to fill the order, while take profit buy orders will be executed when the market is offered at their level in their amount.

Furthermore, some dealing desks may provide partial fills on take profit orders if asked, especially for large transaction amounts that it may not be possible to fill all at once.

Avoid Getting Greedy With Profits

The emotion of greed manifests most often for traders when their trade is profitable and so the trader is making money. This is the nature of greed, to want to make more than you need or have planned out of a trade.

For example, a trader might have had a long position initially go in the money and the market might even have traded up to their planned level for taking profits. Nevertheless, the trader allowed their greed to take over and canceled the take profit sell order specified in their trading plan in the hopes that the market would go considerably higher.

In this situation, the market may not have traded up to the take profit level again after the order was cancelled. As a result, the greedy trader would be left holding what could well then be a losing position or liquidating the trade for a lower overall profit than they could otherwise have achieved by sticking to their plan.

The above example illustrates how greed can influence a trader in making their trading decisions in a profitable trade situation. Basically, having already established a take profit level and entered an order to liquidate their position, the greedy trader instead wants to cancel the order and hold out for a larger profit instead.

Beware Using Too Much Leverage

Add a highly leveraged trading position in an under funded trading account to the already considerable risk involved in trading forex, and the amount of time for the account to be completely consumed by a relatively common market price swing is often greatly reduced.

Overall, margin and leverage can benefit only those who know how to use them wisely, much like many good tools. Make sure that leverage works on your behalf, otherwise losses can accrue much faster than on an unleveraged trading position. Read more on the risks with leverage here.

Please also see these top money management tips.

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.