Forex risk management enables you to apply some rules and measures to minimise any negative impact of a forex trade. An effective plan needs some proper planning from the outset since it's better to have a risk management strategy in place before you actually start trading.
Following are the most effective forex risk management strategies:
- 1.Understand the forex market
The forex market is created with currencies from all over the world, like GBP, USD, JPY, AUD, CHF, and ZAR. Forex - also known as foreign exchange or FX - is mainly driven by the forces of supply and demand.
Forex trading works like every other exchange where you are purchasing one asset using a currency - and the market price shows you how much of one currency you need to spend in order to purchase another.
The first currency that appears in a forex pair quotation is known as the base currency, and the second one is known as the quote currency. The price that is displayed on a chart will always be the quote currency - it represents the amount of the quote currency you need to spend in order to buy 1 unit of the base currency. For example, if the GBP/USD currency exchange price is 1.25000, it means you'd have to give $1.25 to buy £1.
There are three various types of forex market:
- Spot market
- Forward market
- Futures market
The physical exchange of a currency pair takes place at the exact point when the trade is settled - i.e. on the spot
The physical exchange of a currency pair takes place at the exact point when the trade is settled - i.e. on the spot
A contract is agreed to purchase or sell a set amount of a currency at a set amount and time in the future.
- 2. Get a grasp on leverage
When you closely look at forex price movements with spread bets or CFDs, you will have to be trading on leverage. This helps you to get total market exposure from a small initial deposit - known as margin.
While trading on leverage has its advantages, there are also potential downgrades - like the possibility of magnified losses.
Let's assume that you decide to trade GBP/USD using CFDs, and the pair is trading at $1.22485, with a price of $1.22490 and a selling price of $1.22480. You are thinking that the pound is set to gain value against the US dollar, so you decided to purchase a mini GBP/USD contract at $1.22490.
For this type of case, purchasing a single mini GBP/USD CFD is the equivalent of trading £10,000 for $12,249. You decide to purchase three CFDs, giving you a net position size of $36,747 (£30,000). However, as you're trading the forex pair using leverage, your margin will be 3.33%, which is $1223.67 (£990).
- 3. Build a good trading plan
A proper trading strategy can help make your FX trading much easier by acting as your personal decision-making tool. It can also help you to maintain the rules and regulation in the volatile forex market. The purpose of this strategy is to answer important questions, such as what, when, why, and how much to trade.
It is very much important for your forex trading strategy to be personal to you. It's no good copying someone else's strategy because that person may have different goals, attitudes, and ideas. They will also have a different amount of time and money to dedicate to trading.
A trading diary is another important tool you can use to keep a record of everything that occurs when you trade - from your entry and exit points to your emotional state at the time.
- 4. Set a risk-reward ratio
In each and every trade, the risk you take with your capital should be worthwhile. Mainly, you need your profit to outweigh your losses - making money in the long term, even if you lose on individual trades. As part of your forex trading strategy, you must set your risk-reward ratio to quantify the worth of trade.
To find that ratio, compare the amount of money you're risking on an FX trade to the total gain. For example, if the maximum potential loss (risk) on trade is £200 and the maximum potential gain is £600, the risk-reward ratio is 1:3. So, if you placed 10 trades using this ratio and you were successful on just three of them, you would have made £400, although you are right only 30% of the time.
- 5. Use stops and limits
Because the forex market is volatile, it is important to decide on the starting and exit points of your trade before you open a position. You can do this using different stops and limits:
- Normal stops will close your position automatically if the market moves against you. However, you have no guarantee against slippage
- Guaranteed stops will always be closed out at exactly the price you specified, eliminating the risk of slippage
- Trailing stops will follow positive price movements and close all your position if the market moves against you
- Limit orders will follow your net profit target and close your position when the share price hits your chosen level.
- 6. Manage your emotions
Volatility in the FX market can also cause effect on your emotions - and if there's one important component that affects the success of every trade you make, it's you. Emotions such as fear, greed, temptation, doubt and anxiety could either entice you to trade or cloud your decision. Either way, if your feelings get in the way of your decision-making, it could affect the outcome of your trades.
- 7. Keep an eye on news and events
Making proper predictions about the price movements of currency pairs can be hard, as there are many factors that could cause the market to fluctuate. To make sure you're not caught off guard, keep an eye on central bank decisions and announcements, political news, and market sentiment.
- 8. Start with a demo account
Our demo account aims to recreate the experience of real trading as closely as possible, enabling you to get a feel for how the forex market works. The main difference between a demo and a live account is that with a demo, you won't lose any real money - meaning you can build your trading confidence in a risk-free environment. When you open a demo account with us, you'll get immediate access to a version of our online platform, along with £10,000 in virtual funds.
