Forex risk management: how to trade and not to go broke

Forex risk management:
an alphabet for those who love money

Risks at Forex are caused by the structure of the market. It is the sphere of the most severe competition of the capitals, special knowledge, and human characters.

Once the great Warren Buffett asked ambitious newcomers:

If you are so smart, then why am I so rich?
Warren Buffett

If you have come to the market to play, then you will be able (very seldom!) to win, but with probability of 90% your money will go to a pocket of the more professional and competent players. Let's also ask the famous investor for advice and try to understand − why is this so?

For whom this article is?

This article is for those who have come to the financial market to work and to earn steadily, and it means that:

  • you have a correct understanding of the market`s structure, and, in particular, from where money appears at the market and where they “leave” then;
  • you realize a possibility of the losses even before the opening of the first transaction;
  • you have made competent Forex risk management as a basis of the trading strategy.

Remember: if you are in profit, then someone from other participants at a loss. Opportunities to lose and opportunities to earn are identical for all.

Warren Buffett on this topic spoke more harshly:

Never invest in a business where you do not understand anything.
Warren Buffett

Forex risk management means:

  • understanding (or identification) of all possible risks for each transaction;
  • the correct assessment of the risks to which the transaction is exposed now;
  • planning (the maximum elimination) of risks which can be avoided without essential loss of profit;
  • continuous monitoring of a situation from the possible losses point of view;
  • fast effective actions for the risk reduction if the price has gone against you.

Risks at Forex according to their importance are divided on organizational, trading and psychological types.

Organizational risks

Usually, organizational risks include the following: a right choice of the broker, a right choice of a trading account manager (trader) and the reasonable organization of the work if you trade yourself.

Each section requires detailed presentation − we will do it in the following articles, but for now, let's note the main task for a beginner who wants to stay on the market as long as possible:

Control of the reasonable leverage level

The principle of the marginal trade allows you to operate at the market with volumes much bigger than the volumes really secured by your deposit.

But be not greedy! In order to count proportionally the volume of the opened positions not only to the deposit size, but also to the level of the broker’s credit: the leverage is higher and the risk of the fast losses in case of the price movement against you is also higher.

Remember: the broker, “lending” you leverage, will never allow you to trade on credit and without the slightest hesitation will close your account when it achieves the margin call level.

On this subject, another advice from the wise Buffett:

Honesty is a very expensive gift. Do not expect it from cheap people.
Warren Buffett

Trading risks

For reduction of the trading losses it is necessary:

  • to perform the analysis of the market before you open the transaction

The analysis consists of the preliminary technical analysis (trend, price extreme, turning levels) and fundamental analysis (news, correlation of the connected assets) of the trade situation.

Only if you can accurately answer yourself why it is necessary: to buy/sell, open/close, and expose stop/to include a trailing – the transaction will bring you if not a super-profit, but a personal confidence in the correct decision.

According to Buffett:

It is better to be sure of a good result than to hope for an excellent.
Warren Buffett
  • compliance with the strategy and trading plan

Forex risk management depends on your trade principles and a working algorithm irrespective of whether you have developed trade system independently, have lent it, have bought from the friend or have downloaded it free in the network.

The point is:

it is necessary to stick to the trading plan rigidly under any conditions. It will facilitate the further analysis of the mistakes and will lower emotional pressure.

  • rigidly established admissible losses’ percent

You should carry out the regular risk control of losses for the period (day, week, month) with obligatory compliance with the critical level of losses after which any trade stops are necessary and the careful analysis of the trade actions.

  • the fixed level of the mortgage means

As a rule, the minimum level of mortgage in open transactions means no more than 1,5-3% of the deposit’s amount. Even if the current transaction seems attractive to you, don't make investments in it more than your critical level – any price throw is capable to destroy quickly not only the current profit, but also to drain all deposit.

At a competent Forex risk management 7-10% of a deposit is considered the critical level of the pledge.

Remember: the purpose of any trade is to earn a maximum of profit not only at the minimum losses, but also by means of the minimum pledge.

  • obligatory diversification of the transactions

Look at it this way:

The well-known paroemia about problems of investments in one basket is still relevant. In order to trade asset that most actively moves – use the high mutual correlation of the trade assets for receiving an additional profit (for example, gold and Australian dollar, the index of dollar and euro).

Remember: when opening the mutually correlating transactions it is necessary to control especially attentively a condition of the overall mortage means balance.

Warren Buffett advises:

Never test the depth of river with both feet.
Warren Buffett
  • obligatory usage of the technical methods of the loss restriction

Classical Forex risk management demands that levels of the stop orders should have been counted before an entrance. Most often it means the application of the stop for any position. But even when opening the transaction where you don't plan to put Stop Loss at once – you have to know precisely at what price you will prefer to face a loss instead of continuing to hold the transaction.

It appeals also to the strategy in which the usage of the limit turning warrants instead of the stop warrants is planned. Using of the Stop Loss on time is also possible, if during some period some objectives about profit aren't achieved, then the transaction will be closed at the scheduled time by stop with the minimum losses.

Remember: if you have current profit, it should be fixed partially at the possible turning levels.

As Buffett mentions in his the most popular book:

The most important thing to do if you find yourself in a hole is to stop digging.
Warren Buffett

Psychological risks

Psychological factors of the Forex risk management include:

  • control of the trading actions

It is usually means the ability to recognize the mistakes and to stop in time. All of us can be mistaken – but losses need to be fixed in time, that is not about to “play too long” and “not to recoup”.

But here’s the problem:

the market can't be outgamed, you have to be friends with the market and never to trade against a global trend. Of course, if only you are not Warren Buffett or U.S. FRS and don't form this trend yourself.

If you have a choice, it is more important to say “no” correctly than “yes”.
Warren Buffett

Remember: the liquidity of the financial market is not limited, it means all will have enough money. Your first task is not to take away others, but not to give up yours.

  • control of an emotional condition

During the trading any destabilizing emotions (fear, envy, passion, greed, panic) and the irritating factors (external noise, advices of the people around, technical problems) are inadmissible. Choose for yourself comfortable working conditions and a trading strategy with the risk level which is psychologically accepted for you: aggressive, moderate or conservative.

Remember: a trading deposit is your real money and nobody will protect them, except you.

And what is the result?

Forex risk management isn't a guarantee of a profitable trade at all, but is an obligatory component of the successful trade strategy.

The comprehension and sticking to the money management base are especially necessary for beginners to avoid a nervous breakdown and a pavor caused by the fast uncontrollable losses. In process of acquisition of the trade experience methods of the risk management have to be improved and adapted to the modern trade tools and a real market situation.

The correct money management allows reducing losses, to enlarge profit and to keep earnings. For the purpose of losses minimization before the trade you should surely understand yourself. Each trader has the limit of the admissible losses. If the price steadily goes against you – fix losses until they became critical.

The market began not yesterday and will end not tomorrow. It means your best entry points are still ahead.

Remember: trading strategy has to have a profitable history, at least, at an average distance (not less than 6 months). While you have no such strategy – it is impossible to start trade on real money.

Try It Yourself

Trading psychology is one of the essential pillars of the Forex success, so even if you are an experienced trader, you shouldn’t dismiss a trading psychology advice.

Do you need a comfortable space in order to take control over your emotions and get prepared to the live trading?

Simply Forex Tester for free. In addition, you will receive 23 years of free historical data (easily downloadable straight from the software).

Grow your patience, boost your trading skills, learn to avoid psychological traps without drawing your live account.

Before opening trade transactions, you can always check your strategy with the help of ForexTester software − on real quotations of any asset and in various trading conditions.

Share your personal risk management experience at Forex. Was this article useful for you? It is important for us to know your opinion!


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