Risk management is the single most important concept to learn when trading the forex markets. Without good money management an exceptionally gifted trader will lose just as much as a bad trader.
So, while a good risk management system may not fully rescue a losing strategy, a winning strategy cannot possibly succeed without good risk management.
Guest post by FXTM
Position size
Before starting to trade forex you need enough capital in the first place to trade effectively. You should have enough to be able to comfortably bet 1 or 2% of your capital on any trade. If you do not, it is unlikely that you will last too long as a trader.
It stands to reason that if you bet too much you are likely to lose too much when you are wrong while if you bet too little, you won’t make enough to make trading worthwhile. This is the key to deciding on the correct position size.
Typically, professional traders will bet only a very small percentage (perhaps 1 or 2%) on each trade. And they will rarely exceed a maximum portfolio exposure of, say, 20%.
However, it is important to note that not every trader uses the same risk management settings.
Rather, successful risk management relies on careful evaluation of your trading strategy to come up with the optimal position size.
In other words you must find the percentage exposure that allows your capital to increase at its most optimal rate.
Betting your entire fund on one trade is the worst thing you can possibly do since you will always go broke sooner or later.
Stops
Stops are important in trading to guard against losses or extreme price moves.
Putting a stop order into the market at a certain level means that if your trade hits that level, it will be stopped out for a loss. This may sound bad, but what it does is guarantee that that trade cannot drop any further and cause a much bigger loss.
However good stops are for protecting capital, they must be used with care. All too many traders place their stops in the market without much thought – perhaps specifying an arbitrary level from the market, such as 30 pips away). However, there is evidence that stops can actually harm a trading strategy if not placed correctly.
You should therefore analyse the placing of your stops extremely carefully, and only place them where you know they will improve the expectancy of your strategy.
DIversification
One method traders use to protect their capital in the markets is diversification – which has been described as the only free lunch in the investment world, since it can help reduce risk while also improving returns.
Diversification is easy in the forex markets since there are so many correlated currency pairs. For example, if you are long EURUSD, you can diversify by going short EURGBP. This is also called hedging.
However, in order to successfully diversify, it is important to choose trades that you believe will be both win – in other words, you must not hedge just for the sake of hedging.
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