Essential risk management knowledge for foreign exchange trading

"Don't always think about making profits, think about how to protect the profits you have already earned." - Legendary Wall Street Trader Paul Tudor Jones

A quote from Tudor Jones sums up what risk management is. Risk management is finding ways to control losses. You have to know how much risk you are taking and how much you can afford.

Successful traders are highly risk-aware. More than 80% of top traders believe that risk management is the top trading quality a trader must have. Many top traders' advice to beginners in foreign exchange trading is to improve their risk management skills.

Why is risk management important in foreign exchange trading?

Many Forex traders see trading as an opportunity to make money, but they tend to ignore the potential risks. When the market is moving in the opposite direction, traders can minimize losses by engaging in risk management.

Traders who incorporate risk management into their trading strategies at all times can gain from homeopathic trades and minimize losses from contrarian trades. The main risk management methods include stop-loss, limit, and portfolio.

The risk for traders who do not use limits in their trading is that they may want the market to turn in a direction that causes them to hold positions against the trend for too long. This is also the first mistake most traders make, and we have summarized many other mistakes traders make in the Successful Trader's Guide.

How to manage risk when trading?

Here are five tips for risk management when trading:

1. Pre-determined risk/risk exposure

2. Select the optimum stop loss level

3. Diversify your portfolio: the less relevant the better

4. Ensure that risk is consistent with emotional management

5. Set a positive risk-reward ratio

1) Pre-determined risk/risk exposure

Risk is inherent in every trade, which is why it is important to prioritize the level of risk you can take before entering the market. In general, the risk of a single trade cannot exceed 1% of the account equity, and the risk of all positions cannot exceed 5% of the account equity. Assuming your account total is $10,000, the maximum loss for a single trade cannot exceed $100. Traders need to judge their position size based on the distance between the stop loss point and the entry point to ensure that the maximum risk does not exceed $100.

The advantage of this approach is that it can help investors maximize their guaranteed account equity after several failed trades. In addition, by pre-determining risk/risk exposure, investors can take advantage of new opportunities in the market to obtain free margin, which also avoids the situation of having to give up new opportunities because the margin of existing trades is stuck.

2) Choose the optimum stop loss level

There are many ways for investors to set stop losses. Here are three common methods:

Moving Average: Long/Short stops can be set above/below the moving average. The following figure shows how to use moving averages to make dynamic stops.

Support and Resistance: Set a long stop just below the support level, or a short stop just above the resistance level, as shown in the figure below.

Use ATR to set a stop loss: Through the ATR indicator, a trailing stop can be placed on a position. As shown in the figure below, if the ATR value for a certain period of time is 135.8, then the stop loss can be set above 135.8 points of the entry price. If the market direction is consistent with the investor's position direction, the investor can use a trailing stop to lock in the profit, while maintaining the same stop loss distance.

3) Diversify your portfolio and the less relevant your portfolio is, the better

It is not enough for investors to always adhere to the above 1% principle in trading (the risk of a single transaction cannot exceed 1% of the net worth of the account). When conducting multiple transactions, it is also necessary to ensure the correlation of the portfolio. The lower the correlation, the less risk the account bears. When the market direction is in line with the position direction, the highly correlated investor portfolio will undoubtedly multiply the profit, but if the opposite direction is taken, the investor's loss will also multiply.

4) Ensure that risk is consistent with emotional management

One of the pitfalls that investors often encounter in trading is that when certain trades are profitable, the human greedy nature will tempt investors to further increase the size of their positions, and then face the risk of liquidation. A mature trader can indeed increase the position of the existing position when the position is profitable, but at the same time, the risk management should also be more strict and cautious.

5) Set a positive risk-reward ratio

It is very important to set a positive risk-reward ratio when trading. Setting a positive risk-reward ratio while ensuring that the risk of a single transaction does not exceed 1% of the net account value can help investors feel more at ease when trading.

The risk-reward ratio refers to the ratio of the number of points an investor is willing to take on a single transaction to the number of points they hope to return. A 1:2 risk-reward ratio means that once the transaction is triggered, investors are willing to risk one point to obtain two points of return.

The magic of the risk-reward ratio lies in its repetitive applicability. We also studied in the Successful Traders' Guide that traders who use a positive risk-reward ratio tend to be more profitable than a negative risk-reward ratio. As long as the positive risk-reward ratio is maintained at all times during the trade, even if only 50% of the trades are profitable, the investor's entire trade is still successful.

Notes: When the trading direction is correct, but the price has not yet reached the target point, it will turn down to trigger the stop loss point. Investors often feel very frustrated by this. The way to avoid this situation is to close half of the position to lock in profits when the price moves closer to the target price, and then set the stop loss at the break-even point, so that the remaining position is a risk-free trade.