What is risk management?
In its most basic form, risk management in Forex means limiting a trader’s exposure to trades that threaten their accounts. In practice, this means identifying the trades that are most suited to your individual objectives and the risk/reward ration you are willing to accept, and ensuring that you have a proper exit strategy should the trade not go in the direction you had originally anticipated.
Deciding on a risk/reward ratio for your trades goes beyond determining how much money to invest in a position. It also means choosing a trade where the risk of the position unexpectedly moving in an unfavorable way is minimized. Properly identifying the right trade to make requires knowledge of market analysis, both technical and fundamental. Technical analysis makes it significantly easier to identify the potential volatility of a trade before opening it, as well as the direction it could move in. Fundamental analysis will tell you about any impending news events that could potentially affect the trade.
The next step to risk management, after deciding what position to open, is identifying the exit points in a trade, whether it is profitable or not. In our next section, we will be going over how to properly use stop losses and take profits.
Controlling your trades: stop losses and take profits
Despite being one of the most effective tools to managing Forex risk, the number of traders, (especially beginners), who fail to use stop losses and take profits is shocking. In a world where extreme market movements can occur for seemingly no reason, establishing pre-defined points where to exit a position is one of the simplest, yet most effective ways to safeguard funds and ensure a long trading career.
Simply put, a stop loss is a specific price point where an open position will trigger an automatic closure of the trade at available market prices. It is important to indicate here that stop loss trades are sent to the market as Market Orders, meaning a stop loss is searching for the best available price for immediate execution. Such orders may receive worse price than initially requested during market volatility. With stop loss orders, traders can determine the target loss they are willing to take on a position before a position is closed. Advanced traders who are more familiar with technical analysis will also place stop losses at specific points where they feel a financial asset will extend its existing trend instead of reversing, thereby taking the position deeper into losing territory. Let’s look at an example. By analyzing the chart below, we could determine that a potentially good stop loss on a EUR/USD buy position would be around 1.2360, simply based on the number of times the pair unsuccessfully tried to break below that level (circled in blue). By placing our stop loss at this point, we are saying that once the pair moves below 1.2360, it will have broken its support level and could continue downward, meaning it is probably a good time to exit this position.
Figure 1: Identifying the right place to put your stop loss is one of the keys to risk management
Take profits work in the opposite way from stop losses. Instead of assigning an exit point from a losing position, traders pick a price point to exit a profitable position. Take profits are typically placed at points that the trader expects a position to stop being profitable, or where a trend reversal is expected to take place.
Let’s look at an example. In the chart below, we see that the pair unsuccessfully tried to move above the 1.8280 level twice before, (circled in blue). We can therefore say that if we are taking a buy position on the pair, a good take profit would be around 1.8280, because we do not see the pair moving above this level and a downward correction is likely to occur once it reaches it.
Figure 2: Take profits allow you to exit a profitable position before it reverses course
Often times, traders will feel tempted to remove their take profits or stop losses because they “feel” that a position will move in their direction. This type of undisciplined behavior is the surest way to cancel even the best thought out risk management.