Forex Risk Management Strategies: How and When to Walk Away

Forex traders should keep an eye out for quite a few things if they want to limit the risks associated with active trading. We’ve all seen it; many traders will follow fads instead of paying attention to the proper management of their money, and as a result, they will lose money unnecessarily.

Two of the main reasons why forex traders lose money are stop-losses that aren’t used properly and unnecessarily large trading positions that are held far too long. Improperly used stop-losses are especially troublesome for novice traders who don’t have the ability to plan long-term strategies around them.

If you’re looking to become a better, more knowledgeable trader, then read on to learn about the risk management strategies every forex trader should know.

Stand by Stop-Losses

Entering a trade with only calculated profits in mind can be disastrous for your wallet; you must also calculate a protective stop-loss. You should determine a realistic risk-to-reward ratio, which will help limit drawdowns and assist you in selecting essential stop-losses and target limits for your trades.

A stop-loss limits your losses by setting an order a defined number of pips away from your entry point or a certain percentage below the price of purchase. This limits the total amount you can lose. There are a few common types of stop-losses used in forex trading:

Sell-stop

This order triggers a sale of held assets when the value of those assets hits or moves below a set price. This is the most common way to control your risk in a forex trade because it bails you out of a position if the price action moves contrary to your expectations.

Limit order

With this type of trade, you only enter or exit a position at a predetermined price. Limit orders are a great tool to set your profit goal and can be a great strategy for controlling risk and maximizing profit in situations where you believe currency pairs will fail to break above or below existing lines of support or resistance.

Trailing stop loss

This strategy involves the process, often manually performed, of readjusting the stop-loss on a position as the holdings increase in value. For example, if you open a position with a stop-loss and the currency pair then increases in value 2%, you might decide to set a trailing stop-loss at a 1.8% profit, locking in some amount of profit while giving the position space to continue increasing in value. As the position value grows, you may continue to move this stop-loss up to optimize potential returns while minimizing risk.

It can be difficult to accept a hit, but a stop-loss essentially means rolling with the punches. It’s a key factor in any risk management strategy.

Take Profits to Protect Your Portfolio

When you pursue profits, it’s important to leave your emotions at the door. Predetermined exit strategies are also important so you don’t let your emotions cloud your judgment and decision-making skills; impulse is your enemy in trading. Logic and discipline will always win the day as the winners run and increase your profits. Small gains may be tempting, but you must be patient in order to maximize your profits.

Avoid manually exiting trades the moment you see things moving against you. This can often do more harm than good; a manual exit is a risky move in its own right. The market moves in a zigzag pattern, which implies that as it moves against you, it’s already planning to move in your favor once more. 

Be patient, make a plan for your trades, and commit to riding out the market. With take-profit orders in effect, you can effectively ride market waves, cashing in when required and protecting your portfolio in the process.

Be Smart About Position Size

Size matters, plain and simple, in forex trading. Always remember that increasing your lot size also increases your risk. If you increase your risk too much too soon, there’s a chance that your account will blow out—especially if you’re using large-scale leverage. 

Many traders only commit a very small percentage of their total account value to any single trade. It’s typical to commit around 1% of your account value for a single trade. To determine position size, you need to know both the monetary value of your desired position based on the value of your account as well as the number of pips being risked in the trade.

If your account value is $10,000, for example, and you’re opening a position on the USD/GBP currency pair, 1% of your account value will be $100. But you also need to factor in the pips per trade. Assuming the number of pips is 200, you would divide $100 by 200 pips, which comes out to $0.50/pip.

Finally, you will want to multiply this value by the known unit-to-pip ratio. Let’s assume for a mini-lot this value is calculated as (10,000 units/$1 per pip). This comes out to 5,000 units of USD/GBP, which is the amount you can purchase while keeping your position size within your desired trading strategy.

Keep in mind that this calculation can change based on many different factors. The number of pips will go a long way toward increasing your risk. The more pips involved, the smaller your ultimate position size can be. Pay attention to pips and unit-to-pip ratios when looking for potential trades to open through your account.

Position size should be determined after great care and thought. Take time to prepare and calculate, which will help you determine the amount of time a recovery will take if you decide to take a big risk. Remember, when it comes to forex trading, increasing your position size and volume isn’t the way to dig yourself out of a hole.

Lean on Indicators to Decide When to Sell

A stop-loss is a forex trader’s best friend when it comes to mitigating risk in any potential trade. But indicators can help you identify shifting market conditions and exit a position before you even reach a stop-loss, thereby preserving more of your capital.

On-balance volume (OBV) is a great tool you can use to track the buying pressure required to sustain uptrends you may be trading on. When volume changes dramatically, it could indicate a turnaround or a price movement that goes against what you have anticipated. In the AUD/GBP chart below, for example, a high OBV trend line indicates a peak in currency price that is followed by a long decline in price:

Similarly, moving-average crosses or price changes can provide instant insights into a shift that increases your relative risk and necessitates a pullout before your losses increase. In the USD/TRY chart below, for example, an MA crossover marks the beginning of a long decline in price while another crossover above the moving average line is then followed by a sustained period of price gain over which the currency price stays above the MA line:

A similar effect occurs when using MACD to trade. When the MACD line crosses over the signal line, it can provide a bullish or bearish signal that corresponds to the shift in the price movement. In the EUR/JPY chart below, multiple price breakouts occur at, or shortly after, the point where the MACD line crosses above the signal line:

Short positions tend to face greater risk when a short-term exponential moving average (EMA)—the 20-day EMA, for example—crosses a longer-term EMA, such as the 50-day. For long positions, the conditions are reversed. A longer-term EMA crossing over a short-term EMA could be a harbinger of more losses to come—losses that can be avoided if you close your position on time. 

Accept That Losing Trades Will Happen

In spite of what other forex traders may tell you, investing is more of a marathon than a sprint. Prepare yourself for losing streaks, both mentally and financially. A streak of 10, 20, or even 30 losing trades in a row is feasible if you place hundreds of trades over a few years. 

Discouragement, unrealistic expectations, and other factors can leave you vulnerable to impulsive trades. Accepting that losses are part and parcel of trading can mentally prepare you for the risks you’re likely to face during every trading session.

Don’t Let Fear and Uncertainty Dictate Your Decisions

Forex trading is a calculated discipline that requires a certain amount of risk in exchange for the opportunity to reap rewards. But even disciplined traders are liable to let their emotions cloud their trade analysis—especially if they’ve suffered unexpected losses and want to get their trading back on track.

Be warned: The risks of emotional trading are severe, especially if you overreact to one financial loss and end up making another bad decision. Assume, for example, that you’re trading with just 1% of your portfolio, which is a standard procedure for many forex traders. If you take a 10% loss on that 1% position, the net loss may sting, but in the grand scheme of things, the impact on your net savings is marginal—just one-tenth of 1%. 

But if you stay in that open position out of a stubborn determination to win back what you’ve lost, you could dig a deep hole for yourself. And the more you lose, the larger your percentages need to be to climb back. If a run of bad trades costs you 10% of your portfolio, you need only an 11% return on your total investments to earn it back. Lose 20%, though, and you need a 25% return. Did things get really bad, and you lost 50%? You have to earn a 100% return to get back to where you started—and even in good market conditions, the odds are against you.

In short, take a breath, and don’t be afraid to take a loss. Trading is a numbers game, and losses are inevitable. Focus on the big picture, and don’t abandon your trading strategy.

Stay Alert to Avoid Mistakes

To succeed with investing and trading, you need to be a lifelong student, particularly of financial and economic matters. You must constantly seek out knowledge of the market, remaining educated on what’s happening with your money. In order to be a successful long-term forex trader, you must realize that the biggest obstacles you face will be your own emotions. 

Over the years, we’ve seen many traders stop learning and effectively let down their guards. This is exactly where the issues start; trading risks automatically increase through a lack of attention or vigilance. When you’re trading, you must stay alert, being aware of your trading activity and the effect on your portfolio of the associated risk.

Any Trading System Can Be Profitable

Realizing that forex traders are survivors first and profitable second is your first step to becoming a successful trader. With the right techniques to manage your money and negate risk, any trading system can become profitable. 

In fact, risk management is highly important in managing your trading efforts. If you risk too much on a single trade, then you lose the full benefit of your system over the long run. Integrate the risk management strategies mentioned above, and, given time, you’ll likely become more successful in your forex trading efforts.