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Forex Risk Analysis And Management Tips

Why Is Forex Risk Management So Important?

Risk analysis and management are the most important subjects to read about before you start Forex trading. They are key concepts to making the most of your investments, and they are not always easy to apply. Many brokers will tempt you with all the benefits, especially relating to leverage, but not clearly explain the possible drawbacks. It can mean that traders easily develop the mindset that trading involves large risks and they should be aiming for huge profits. As a new trader, it can seem easy when you are practising on a demo account, but once it involves real money and real emotions, then everything can change.

Speculate – Don’t Gamble

Trading Forex is about pursuing the opportunities that arise, and risk management is about controlling your risk so that you can be flexible and act when required. When you limit your risk exposure, you are able to continue trading when the market fluctuates or things are not going as planned.

If you trade without using risk analysis and management rules, then you are actually just gambling your money. Forex trading is about speculating and maintaining control over your risk. It will protect you and your investments and can make your trading extremely profitable over time.

The Importance Of Trading Capital

An important aspect of risk is how much capital you have available for trading. You need money to make money, and most new traders are able to open a trading account with as little as $25. However, before you are tempted by any brokers offer, you need to fully understand the terms “margin” and “leverage” and how trading with leverage can significantly affect your risk.

Any risk for each trade should also be a very small percentage of your overall available capital. For new traders, a  good starting figure could be 2%. For example, if you have $10,000 in your trading account, then your maximum loss should be fixed at $200 per trade. This then gives you the protection of being wrong 50 times before you have exhausted your funds.

Understand The Odds

The very first rule of Forex risk management is to understand and calculate the relative odds of a successful trade. This means that you need to fully research and grasp both technical and fundamental analysis and how to use all the relevant tools. Most of the brokers provide comprehensive information and charting packages that are available for free on their trading platform.

For more advanced traders, there are charting software packages that can be purchased to provide special indicators and better functionality. You will also need to study and understand the dynamics and volatility of the Forex market and your own likely psychological triggers. Always remember, that if a risk can be measured, then it can also be managed.

Know When To Cut Your Losses

An important factor of risk management is being in control of your losses. To limit any losses on your trade, you must have either a mental stop or a hard stop and stick with it. A hard stop means that you set a level for your stop loss when you make your trade on the broker’s platform. A mental stop involves setting your own limit on the trade as to how much you will allow the investment to decline.

Setting your stop loss can be difficult, but it needs to limit your risk and make financial sense to you. Once you have set this figure, then don’t change it and fall into the trap of continually revising it. This means that you are not effectively managing your risk and cutting your losses.

Drawing this line in the sand creates the difference between where you entered the trade and where you will close it, and this is your risk. You need to identify this risk as your potential loss and accept it before you enter into any trade.

Use Correct Lot Sizes

A lot is the name for the smallest trade you can place, and they are typically referred to in increments of 1000. Using the correct lot size is critical as it directly impacts on your risk. A standard lot is 100,000 units of the currency and there are also mini-lots and micro-lots available.

Determining the best lot size for your capital and proposed trade can be done using tools like a risk management calculator. This will also help you understand the overall risk involved. It is not an exact science, but if you are just starting out then smaller lots are better, and it is sensible to be conservative. It is important to understand that using large lots for trading when you have a small capital balance carries a much higher risk.

Track Your Overall Exposure

While opting for a smaller lot size is a good decision, do not be tempted to open too many of them. With Forex trading, there is also a large risk attached to the changing foreign exchange rates, which can directly affect the transactions of both domestic and foreign currencies. It is also important to research and clearly understand the correlations between currency pairs and the terms “go short” and “go long”.

As an example, if you go short on CHF/USD and long on USD/EUR, then you are doubly exposing yourself to the risk of a price decrease in the USD. Keeping a close watch on your overall exposure and limiting it, will of course, reduce your overall risk.

Beware Of Using Leverage

One of the main benefits that attract traders to the Forex markets is the high leverage available. Because of the market’s liquidity, it is easy and fast to cut out of any position and manage any leveraged positions. However, the use of leverage also significantly magnifies your risks. It is basically the use of the broker’s money instead of your own.

So for instance, you could make a capital deposit of just $500 and actually be able to trade with $50,000. This would be advertised by the broker as a 100:1 leverage and it might sound very attractive. However, remember that your risks in any leveraged situation are increased too, so you could end up with a $500 loss instead of $50. Of course, if you are leveraged, you can also make some good profits very quickly.

Take Your Profit Regularly

One of the best ways to limit your risk is by taking profit regularly. Doing this means that you reduce your exposure and it always pays to protect any gains that you have made. Taking partial profit, or even just adjusting stop-loss orders and locking in any gains, is the sensible thing to do. The only sure way to protect your profits is to close the trade according to your strategy and take them before you lose them.

Remember too that it’s wise to make regular withdrawals from the profit held in your trading account. If you leave it there, it’s tempting to make trading decisions which are not in your plan and will increase your risk. Always maintain your balance at your pre-planned amount, allowing you to trade at a comfortable risk level.

Know Your Trading Psychology

Any trader has to take numerous decisions and be totally responsible for their outcomes. Losses are part of the everyday trading process, so you must be able to accept them when they happen, and not view them as failures. Having a risk management plan and sticking to it means that you will take these losses quickly. Any other outcome is a failure to properly manage your trading and risk.

Trying to second-guess the market or change your strategy is simply gambling and can result in a much worse situation. The solution is to keep a journal and to understand your own psychology and habits. Always be honest and recognise the times that fear or your ego has resulted in you making the wrong decisions or resulted in you returning to bad trading habits.

Take A Disciplined Approach

Some risk is inherent to Forex trading, but by using risk analysis and management to measure it, you can effectively minimise it. It’s all about keeping that risk under your control. Any risk management plan revolves around your strategy and can make the difference between success and failure no matter how experienced you may be. Forex risk management should be a combination of multiple factors and ideas, from limiting your lot size and knowing when to take a loss to only trading during certain hours.

A disciplined approach towards taking on risk is the only way to ensure rewards and a good profit over time. The Forex market trades every day around the clock, but don’t get pulled into all the action. Choose your trading spots and your timing with care and ensure that you take a step back regularly. Use this free time to catch up on charting, fundamental analysis and reviewing your risk management strategy and plan. It is the most essential prerequisite for any successful active Forex trading.