Importance of Risk Management In Forex | Apexum

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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 Trader’s Side

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.

–    Use 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, high-volatility periods.

–    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 Broker’s Side

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 month/quarter/year.

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