If you are considering a career in Forex trading, you cannot ignore the statistics that show 60 – 90% of traders lose money. While this may seem discouraging, the main reason why most traders fail is that they don’t follow the simple rules of risk management. Before we outline some risk management rules, it’s important to understand why it is so difficult to follow them.
Why don’t traders stick to their risk management rules?
While many skills need to be mastered to trade successfully in the Forex market, none are as crucial as the trader’s mindset. Forex trading is stressful for many people and can become highly emotional, especially when faced with significant financial losses. Some days traders will win more than they lose, but even on the most profitable days, there will typically be a few losing trades. Successful traders are comfortable with loss, can contain their emotions, think quickly, and stick to a risk management strategy.
What is risk management?
Risk management is the practice of managing the potential risks associated with trading. It involves developing strategies that limit your exposure to potential losses while maximizing your chances for profits. Creating a successful risk-management strategy takes time, education, and patience, but there are a few simple ways to minimise risk:
- Start with a demo account: One of the most important ways to reduce risk is by using a demo account before opening a live account. Demo accounts recreate the experience of real trading as closely as possible, allowing traders to test the broker’s platforms and get a feel for real market movements. They also allow traders to practice different trading strategies, such as setting up take profit and stop-losses, and practicing with different technical indicators, which are very important in real trading.
The main difference between a demo and a live account is that you won’t be risking real money, so you can try out different strategies and build your confidence in a risk-free trading environment.
- Use Leverage Responsibly: Forex traders often use leverage to increase their buying power. Leverage allows traders to open larger positions with smaller amounts of capital. Leverage is a very appealing aspect of trading, as it can multiply winnings immensely. But it is a double-edged sword – it is important to remember that losses can be multiplied just as quickly. The improper use of leverage will make long-term success almost impossible in the forex market. This is one of the reasons that top regulators like the FCA of the UK and ASIC of Australia have limited leverage to 30:1 on Forex trading.
Traders should only use leverage when necessary, and beginner traders should start with low leverage levels while they learn how to trade.
- Build a trading plan and stick to it: One of the most important factors in reducing your risk is being disciplined to stick to a trading plan. Trading plans act as a personal decision-making tool and are unique to each trader. They have well-defined rules, including how much money you are comfortable risking, which trading style you employ (scalping, day trading, swing trading, or positional trading), how often you trade, and your trading goals. Your plan should outline your risk management rules and exactly how you will enter and exit trades for both winning and losing trades.
Having a trading plan prevents you from trading emotionally. For example, if you lose your allocated capital for that day your immediate instinct may be to trade again. But a trading plan will ensure that you stick to your pre-defined strategy.
To inform their trading plans, many traders keep a trading journal to record every trade, including exit and entry points, technical indicators, and your emotional state on the day.
- ALWAYS use a stop-loss: The final tip for preventing significant losses in Forex trading is to use a stop-loss on every trade you open. One of the most powerful tools in a trader’s arsenal, a stop-loss order is an instruction given to a broker specifying the maximum loss that can be incurred on a position. A stop-loss will automatically close your trade if the price falls below a pre-defined level and prevent you from losing more than you can afford if the market turns against you.
While Forex trading can present great opportunities to make money, it is important to understand that a great deal of risk is involved. Starting with a demo account, setting stop losses, using leverage responsibly, and sticking to a trading strategy are all critical elements of successful risk management in forex trading that can help ensure your trades are profitable over time.
