When discussing forex, be in online or offline, there is one particular subject that will, somehow, make its way into the dialogue, no matter what: risk management.
The reason why it generates such debate is that, oftentimes, traders want two things that don’t exactly go well together. They want to win big, while at the same time, reducing the size of potential losses. Unfortunately, in order to win big, you sometimes need to take greater risks.
The secret of maintaining a constant balance in your account, and ensure you don’t run low on capital is proper risk management. Knowing when to risk and, most importantly, how, results are less stressful trading, controlled loses and a much bigger chance to make profits. But how can you manage to control risks? We will be exploring a few of the most reliable risk management strategies and how you can apply them to your everyday trading.
Never invest more than you can afford
This should be considered the number one rule of trading, no matter your market of choice. Managing risks means much more than paying attention to your trading strategy. It means ensuring that you don’t jeopardize your financial stability, no matter what.
Make sure to never invest money you can’t afford to lose. This means that, before making a deposit, you should always take care of your day to day expenses. Trading is never guaranteed to bring you profits, as the market can move in one direction or another at any given time.
On top of that, trading money you don’t have, or money that you may need for something else, in the hopes of making a profit, will add much more pressure on you and make you more open to mistakes. Not to mention the disappointment or trouble losing that money would bring.
Keep a financial diary, make sure you take care of bills, food, and any other expenses you may have before you trade, and always keep a backup fund, in case the market is not on your side.
Determine your risk tolerance
To manage risks, you must first be aware of your risk tolerance. This does not only mean how adventurous you are, but rather how much you can afford to invest, and how aggressive a trader you can be, based on your financial situation and overall objectives.
To determine your risk tolerance, you need to take into consideration some important factors. Age, for example, is extremely important. If you are young, you have more time to build your wealth, meaning you can afford to take a much bigger risk than someone over 50.
Currency trading knowledge is another important factor, In the beginning, your risk tolerance may be lower, as you don’t know the market that well, but once you start learning, you will be able to determine when risking more is worth it.
Financial stability and overall lifestyle are also something you should take into consideration. If you have a regular income, you may be able to afford some losses here and there, without jeopardizing your financial stability.
Choose a type of broker that suits your trading style
There are many types of brokers out there, each of them having their own set of advantages and disadvantages that can influence your profit.
A dealing desk (DD) broker, for example, is always a market maker, meaning they will offer fixed spreads, and choose to go below or above the market prices with their quote.
A No dealing desk broker will provide access to the interbank market, meaning there is no price requoting when trading with them. Their spreads are usually lower, but because they are not fixed, they can increase significantly due to the high volatility of the market.
An electronic communication network (ECN) broker will display real-time order book info, meaning they are amongst the most transparent type of brokers on the market. When you explore the list of ECN Forex Brokers, keep in mind that, they usually make money by charging commissions on the trader volume.
Establish a risk/reward ratio
In the beginning, your risk to reward ratio (RRR) should be set to 1:3. This meant you are willing to risk one-third of the potential winning amount. This means that, in the long run, even if you experience losses, you will still be able to turn the odds into your favor and even out multiple losses with a few big wins. As you get more experienced, you will be able to adapt this ratio based on the trading strategy that you like most.
In terms of effectiveness, it was revealed that traders with an RRR of 2:1 or 3:1 end up making the most profits, but you need to ensure you know your game before you start playing with the ratio.
In theory, most traders will only win 50% of the trades they enter, meaning that, half of the time, they will lose. The key is to turn the odds in your favor in a way that allows you to make a profit, even if half of the time, you lose.
Control risk per trade percentage
When trading, it is not enough to just calculate a risk per reward ratio, but also take into consideration the trading capital you have available. This will ensure a much lower risk of running out of capital after a few big losses.
Experts advise you to only invest a small percentage of your total capital with every trade. In the beginning, you should set the risk per trade percentage at 2, meaning that, if you have a $5,000, your maximum risk should be $100 per trade.
Although you may want to invest a bit more in the beginning, to try and increase your capital, you should try to gain a bit more experience before increasing the risk per trade percentage.
Most traders work with a 5% risk per trade, and sometimes even more, but only because they are more experienced and trust their ability to predict market changes. But even with their experience, some traders still end up on a losing spree, meaning they risk large drawdowns in their account.
Author Bio: M. Rafiq is the brain trust behind multiple ecommerce startups, and has become a thought-leader in the entrepreneurial space by providing wisdom and advice based on his decade of startup success. The digital age has opened opportunity to everyone, and M. Rafiq is passionate about providing opportunity to anyone willing to work both hard and smart.