Importance of Risk Management In Forex
June 17, 2019
Risk management is everything when it comes to
handling money. It is being seen in every-day life, with families handling
their incomes and expenses, in regular businesses, with handling the income and
expenses streams, and even in governments.
A government runs a country on a budget: incomes and
expenditures. A deficit needs to be financed, while a surplus needs to be
invested to produce for future generations (infrastructure projects, education,
culture, and so on).
Having said that, Forex trading is no different. As
long as people understand that, the approach is healthier.
Risk Management on the Retail
The above statements are especially true in the case
of retail traders. They represent less than five percent of the whole Forex
market, and this means they’ll have to adapt to conditions and rules made by
other players, or market participants.
Such players are central and commercial banks (yes,
these two entities have trading departments), liquidity providers, Forex
brokers, etc. Not to mention the growing high-frequency industry here.
Super-computers are programmed to buy and sell
thousands of trades per second, and this makes the market react aggressively,
especially when economic news is released. Retail traders have better chances
to survive if they adapt to these conditions.
The best way to do that is by having a sound money
management plan. As a retail trader, you may think you are in the business of
trading, but, in reality, you’re dealing with a decision-making process ahead
of every trade.
The same is valid when a trade is closed. Taking
profits is as difficult as cutting a loss because fear and greed are two
elements that influence human nature.
The following must be part of any risk-management
system or money management plan a Forex trader has:
– Risk only a
proportion of the trading account. That is, for every trade, risk an exact percentage.
If you’re wrong, the risk on the next trade will be smaller, and chances to
survive on the long run increase exponentially.
– Never be
invested more than 30% of your free margin. If the market goes against you and
the free margin level exceeds 30%, use conditional closing or simply cut from
the open trades until margin comes back below the desired level.
realistic risk-reward ratios. While it is ok to look for trades with 1:10
risk-reward ratios (meaning the trader is risking one pip for ten pips profit),
this is not a realistic approach. Forex markets do move more than other
markets, but they still spend around 70% of the time in consolidation. That
means that a 1:2 or 1:2.5 ratio for the risk-reward is more than normal and
good enough for profitable trading.
– Know the
risk events for the week ahead. Look for the red events (the most important one
in the economic calendar) and how they may influence your technical analysis
and the trading place already in place. Avoid, as much as possible,
– Close your
trades ahead of the weekend, or reduce the margin level to an insignificant one
for the trading account.
The steps above are enough to make sure a trader is
surviving in the Forex market. A plan is a plan, but the most difficult part is
to follow it. It is not the same when it comes to Forex brokers.
Risk Management on the Forex
The Forex broker, on its part, handles risk as every
other business. Depending on the type of the brokerage house, this risk can be
bigger or smaller.
A market maker or a dealing desk is known for keeping
all of the customer’s trades in-house. This brokerage type is earning from
spreads and commissions and it is betting on the 80% chances that the customers
are losing their accounts.
The risk is to be wrong. However, even a bigger risk
is not to find sufficient new customers to replace the ones that, eventually,
will stop trading.
To avoid those risks, many brokerage houses use a
hybrid model: they are passing only some of the trades to the liquidity
providers, and the other share they keep in-house. Through a screening process,
they try to figure out who will survive and who won’t in the market.
A true ECN broker will not have to deal with such
risks. The risk-management of a true ECN broker is identical with the one of
running a regular business: to keep a balance between expenses and incomes in
such a way that the business turns a profit at the end of the