Managing Risk with Forex Trading

There are two main elements to successful trading, which are seeking positive returns and managing risk. Less experienced traders tend to focus on pursuing gains, whether or not they have the means yet to make this happen, and tend to not focus on the risk management side of things anywhere near enough, and this is why most new traders fail at forex as well as any other form of trading.

Due to the nature of forex trading, using high amounts of leverage, both returns and risks are amplified. Unless we are at a point where we can benefit from having our returns magnified, what will happen instead is that just the risks will be accelerated, as there is no trading advantage to multiply yet.

Any time your expectation from trading is negative, risk is all we have, and it’s just a question of how much we’re going to accelerate our negative expectation. If we are making losing bets overall in other words, making bigger bets is just going to propel our losses.

Even when we have a positive expectation, we still need to manage risk and this is still very important, because no matter how significant our advantage is, it’s still going to be subject to drawdowns and even disastrous ones if we’re not careful.

For instance, we may win 3 out of 4 trades on average, but if we are exposed to too much risk when the 1 out of 4 appears, where for instance we are trading with 100:1 leverage and we’re trading daily bars which require that we give at least 1% room to our trades, the first time we see a trade decline by 1% our account becomes wiped out.

While this is an extreme example and few traders are this foolish, unless we manage the outcomes of the trades that don’t go in our favor and ensure that the losses will be quite manageable, even if we get a string of them, we’re not managing risk properly and our trading advantage will be overcome by even normal distributions of probability, let alone events that are on the fringes of it, which we need to well protect against as well.

Managing Risk When Trading with a Negative Expectation

Whether or not you have a positive expectation or a negative one with your trading matters a great deal as far as how you’re going to manage risk trading forex. We may ask ourselves why anyone would trade forex without a positive expectation, but we have to start somewhere, and no one starts out being profitable right away. Even the most brilliant traders have had to go through some sort of learning phase to at least get to the point where it is more likely that they win money rather than lose it.

More gifted traders may get there sooner, but you have to learn to trade first, and while a lot of what it takes to become a successful trader can be learned simply by watching and analyzing, there is no substitute for experience and practical mastery is required to be successful.

We need to be prepared for a period where we’re coming up with and testing various trading ideas where we at the very least don’t have that good of an idea of how things will turn out, and during these times it is typical that traders will start out losing money first before they gain enough skill to move outcomes overall in their favor.

During this phase, it is imperative that we not expose our trading funds to excessive risk, and this in fact will require that we manage risk very tightly, and even appear to overmanage it. This appearance of overmanaging, where we may appear to be too conservative, trading on a simulator for an extended period or trading very small and only gradually increasing our size, we really do need to err on the conservative side during this time.

We may be eager to trade with more meaningful amounts, but unless we are reasonably confident that we have a positive expectation, all we’d end up doing at this point is either increasing our negative expectation or putting our funds too much at risk if there is too much uncertainty surrounding how things may play out at this point in our trading development.

Very few forex traders understand the importance of all this and a lack of proper risk management, usually a heinous lack of it, is the reason why the great majority of forex traders do not succeed and end up giving it up after they have either gone broke or reached their maximum threshold of pain.

It does not ever have to turn out this way provided that we just understand the importance of managing the risks that end up undoing so many forex traders and traders who trade anything in fact. The risk is higher with highly leveraged trading such as forex, contracts for difference, and futures trading, where the risks need to be managed a lot more and our demise will be accelerated when we do not do this.

Risk Management for Successful Forex Traders

Traders who do manage to stay in the game long enough to be profitable are the ones that have at least a sufficient understanding of the importance of risk management in forex trading, and we can say this with complete confidence.

If one trades forex and does not manage risk properly, one will fail, every time. This is not ever just a matter of being lucky because improper risk management will undo any amount of luck and do so in short order.

The reason for this is that while you can get lucky with investing, trading requires a much more active approach and this is actually required with forex, as there is just too much risk involved in trading an approach that is anything but very short term, a few minutes to a few days at most.

A few days is actually very risky with the amount of leverage that we have at our disposal and to do this we need to be very careful to only use a smaller portion of our funds and keep the rest in reserve to manage risk.

Beyond this, we can further water down the leverage we use, but we quickly get to a point where the reductions in size end up producing lesser expectations of return per given amount of risk, where we could have sought returns on a lesser time frame more efficiently. For example, if we’re only using one tenth of our capital in our trades, we’re diluting both our risk and our returns as well and will generally end up with a profit expectation that is significantly less overall than trading with larger sizes over shorter periods.

So, while we are tempted to look at trades we could have made and see that we might have increased our return in a trade by 25% for instance, if we have to cut our size by three quarters to seek this higher return, that isn’t going to make sense. We need three times the return in this case from the longer trade while still managing the risk properly and that just isn’t realistic.

This is all about the interplay between returns and risk and the risk side must be managed first, because without that, we’re risking trouble, and staying out of real trouble needs to be the prime directive here, where we seek returns in that context and in that context only.

This is why successful traders define their risk in a trade by only risking 1-2% of their trading capital, and will avoid strategies that require that more be risked. This is not just a matter of setting stops though as we must also ensure that this maximum loss fits the trading plan.

A profitable trading plan will always involve moves against us where we need to stay in the trade, where these pullbacks are not indicative of our wanting to exit, but if we exceed our risk maximum without our plan indicating us needing to close our positions, we are getting stopped out too soon and our otherwise successful trading plan becomes dashed.

This is why we have to alter our trading size to both contain risk and ensure that we’re able to bear the risk that our trading strategy requires us to, but if we seek trades that require us to reduce our trading size too much, where our profit expectation goes down, we need to rethink things and look to instead seek out a plan where we don’t need to trade so small, which means shortening up the holding time.

The trick here is to set our risk at a manageable level and then, and only then, seek out trading plans which will seek good returns. The trade sizes that we end up using, and the lengths of our trades in turn, will involve seeking to extract the most profit from given moves safely.

Coming Up with a Good Risk Management Plan

If we are not confident that whatever trading plan or plans that we have come up with will be profitable, we need to tread carefully and make sure that no matter what happens we are still left in a comfortable position. This can mean spending quite a bit of time trading on a simulator first, until we at least can be profitable doing that, and then trading very small and moving up gradually once we get ready for the extra pressure that real money trading involves.

Once we do get to the real money phase, we should also fund our account gradually, to avoid the temptation to move up too fast. We might for instance put in a string of good trades and think we’ve made it and decide to trade in full force, and get ourselves in all sorts of trouble if we’re not truly ready, and then think that we have to keep our sizing up to look to recover losses, something that will likely turn out very poorly.

Regardless of what stage we’re at, we always need to define our risk and never risk too much on a trade, and back off further if we start getting evidence that our trading plan may not be as good as we had thought.

Setting hard stops is an absolute requirement, and we should never expose more than 2% of our capital, and even with this in place, this should be used as a protective mechanism and not an exit strategy.

Our exits instead should be above our stops most of the time, where we’re exiting generally based upon things like indicators or price action, how we would normally manage trades, with hard stops functioning as backstops in case the ball gets away so to speak.

In the earlier stages, we also need to leave ourselves fully open to reassessment and be very willing to back up and trade smaller should this be required. We do need to want to move up when our results indicate it is wise, but we also need to be willing to back up should that be wise.

Forex trading can be an extremely lucrative way to make money, provided that we are both willing to put the work into becoming a good forex trader and also have enough wisdom to manage our risk properly along the way. Both are absolutely required.