Understanding Critical Risk Management Concepts in Forex Trading

Risk managment

 

Introduction

Forex trading inherently involves risks. Note that applying risk management does not mean that all your trades will be profitable or that you won’t lose any money. It merely means that if a trade doesn’t go your way, your downside is limited. 

In this article, we’ll look at some of the risks inherent in the forex market and share some of the risk management techniques you can apply to your trading.

Potential Risks in Forex

Volatility Risk

In forex trading, volatility risk occurs when a currency pair’s price fluctuates more rapidly than in preceding trading sessions. Remember that the price of a currency pair reflects all market factors that impact the exchange rate. Therefore, an unexpected development in one of the fundamental elements is bound to cause volatility in the market. 

Factors that result in volatility risk include geopolitical conflicts and domestic political developments. The release of high-impact economic indicators also results in volatility. Such high-impact indicators include employment reports, monetary policy decisions, and inflation data.

Traders can potentially profit from volatility. But when on the wrong side of a trade, volatility can wipe out your trading account. Note that not all assets have the same volatility. For example, SDS trading may have different volatility than trading EUR/USD.

Leverage Risk

It is customary for CFD traders to use leverage. Leverage enables traders to take larger positions compared to the deposits in their trading account. For example, if you have a deposit of $1,000 and trade with a leverage of 1:100, you can open a maximum position worth $100,000. Such leverage magnifies your profit significantly.

Leverage risk arises from the fact that if the market moves against you, your trading account can be wiped out. If the price moves only 1% against your trade in the above example, your $1,000 deposit is wiped out. Note that the higher the leverage, the higher the leverage risk.

Liquidity Risk

In the forex market, a currency pair is highly liquid if there are a high supply and demand. It is relatively easier to trade large volumes of a liquid forex pair without distorting its price. More so, it is rare for a trader to experience slippage when trading highly liquid currency pairs. Liquidity risk arises when trading a currency pair that has less demand and supply. In this case, you might experience delays when opening and closing positions. More so, there are increased chances of slippage, which will reduce your profit or increase your losses.

Interest rate risk

Note that demand for a currency significantly affects its value. In the forex market, the interest rate determines the demand. Naturally, countries with higher interest rates experience a net inflow of capital, which increases the demand for their domestic currency. In the forex market, interest rate differential plays a crucial role in the carry trades. 

The interest rate differential of a currency pair determines if carry traders are bullish or bearish on a currency pair. The interest rate risk arises when there are unexpected interest rate changes in the economy. This exposes traders to unforeseen losses.

Risk Management Measures

Now that you are familiar with the potential risks in the forex market, here are some of the risk management measures you can use.

Using forex pending orders

Forex pending orders are instructions you give to your broker to execute your trade once the market meets some specific conditions. A pending order details your broker’s trade size to run, the currency pair, and the particular market conditions. The pending orders are categorized into buy limit, sell limit, buy stop, sell stop orders. 

With a buy limit order, the broker executes a long trade will when a currency pair’s price reaches a specific level, which is lower than the current market price. For a sell limit order, the broker executes a short trade when the price hits an exact price above the current market price. Similarly, a buy stop order runs a long trade when the price reaches a specific level above the current market price. With a sell stop order, your broker will sell a currency pair if the price hits a particular level lower than the prevailing market price. 

Using forex pending orders helps eliminate the volatility and liquidity risks, resulting in slippages and price gaps. For example, if you use pending orders in platinum trading, your trades will be executed at precise price points.

Using Take profit and Stop Loss

Having a trading plan grounds you to realistic expectations regarding profits to be expected from a trade. The stop loss and take profit levels are set depending on your trading plan and profit goals. You can then use them to enforce your trading plan.

Furthermore, these levels will help mitigate the impact of volatility and interest rate risks. When the price fluctuates rapidly, the take profit will close out your trade once the price touches that level. Similarly, the stop-loss exits your trade even if the price continues trending beyond the levels. They secure your profits and limit your downside exposure.

Avoid using excessive leverage

As we mentioned earlier, leverage risk arises when you use higher leverage, which increases your exposure if the market moves against your trade. Here’s an example when using the leverage of 1:100 and 1:1000 with a deposit of $1,000.

With 1:100 leverage, the market will have to move 1% for your deposit to wipe out. With the leverage of 1:1000, only a 0.1% move against your trade will wipe out your trading account. 

Educate yourself about factors that impact the forex market

The first step in risk management is understanding how the risk may arise. Therefore, you should educate yourself about how geopolitics, economic news releases, and domestic political developments impact the forex market. Use economic calendars and look into historical events and how they moved the forex market. That way, you might be able to gauge the future impacts of such events.

Conclusion

To ensure successful risk management in forex trading, practice all the risk management techniques on a demo account first. This will ensure that you have mastered the before proceeding to live to trade.