What is Risk Management in layman's term?
Forex risk management enables you to implement a set of rules and measures to ensure any negative impact of a forex trade is manageable. An effective strategy requires proper planning from the outset, since it’s better to have a risk management plan in place before you actually start trading.
There are mainly 4 types of risks are associated with forex trading.
Currency Price Risk -
Interest Rate Risk -
Liquidity Risk -
Leverage Risk -
HOW TO MANAGE RISK?
1. Learn Basics
2. Understand and use Leverage appropriately
3. Plan your Trade in advance
4. Follow Risk Reward Ratio
5. Follow level trading with limit orders
6. Control your Emotions
7. Follow Economical Calendar and News
1 LEARN BASICS
The forex market is made up of currencies from all over the world, such as GBP, USD, JPY, AUD, CHF and ZAR. Forex – also known as foreign exchange or FX – is primarily driven by the forces of supply and demand.
Forex trading works like any other exchange where you are buying one asset using a currency – and the market price tells you how much of one currency you need to spend in order to buy another.
The first currency that appears in a forex pair quotation is called the base currency, and the second is called the quote currency. The price displayed on a chart will always be the quote currency – it represents the amount of the quote currency you will need to spend in order to purchase one unit of the base currency. For example, if the gbpusd currency exchange rate is 1.25000, it means you’d have to spend $1.25 to buy £1.
2. UNDERSTAND AND USE LEVERAGE APPROPRIATELY
While trading on leverage has its benefits, there are also potential downsides – such as the possibility of magnified losses.
Let’s say you decide to trade GBP/USD using CFDs, and the pair is trading at $1.22485, with a buy price of $1.22490 and a sell price of $1.22480. You think that the pound is set to gain value against the US dollar, so you decide to buy a mini GBP/USD contract at $1.22490.
In this case, buying a single mini GBP/USD CFD is the equivalent of trading £10,000 for $12,249. You decide to buy three CFDs, giving you a total position size of $36,747 (£30,000). However, because you’re trading the forex pair using leverage, your margin will be 3.33%, which is $1223.67 (£990).
3. PLAN YOUR TRADE IN ADVANCE
A trading plan can help make your FX trading easier by acting as your personal decision-making tool. It can also help you maintain discipline in the volatile forex market. The purpose of this plan is to answer important questions, such as what, when, why, and how much to trade.
It is extremely important for your forex trading plan to be personal to you. It's no good copying someone else's plan, because that person will very likely have different goals, attitudes and ideas. They will also almost certainly have a different amount of time and money to dedicate to trading.
4. FOLLOW RISK REWARD RATIO
In every trade, the risk you take with your capital should be worthwhile. Ideally, you want your profit to outweigh your losses – making money in the long run, even if you lose on individual trades. As part of your forex trading plan, you should set your risk-reward ratio to quantify the worth of a trade.
To find the ratio, compare the amount of money you're risking on an FX trade to the potential gain. For example, if the maximum potential loss (risk) on a trade is £200 and the maximum potential gain is £600, the risk-reward ratio is 1:3. So, if you placed ten trades using this ratio and were successful on just three of them, you would have made £400, despite only being right 30% of the time.
Accuracy required to maintain RRR
5. FOLLOW LEVEL TRADING WITH LIMIT ORDERS
Because the forex market is particularly volatile, it is very important to decide on the entry and exit points of your trade before you open a position. You can do this using various stops and limits:
6. CONTROL YOUR EMOITONS
Volatility in the forex market can also wreak havoc on your emotions – and if there's one key 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 judgment. Either way, if your feelings get in the way of your decision-making, it could harm the outcome of your trades.
7. FOLLOW ECONOMICAL CALENDAR AND NEWS
Making predictions about the price movements of currency pairs can be difficult, 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.