Risk Management Techniques in Online Forex Trading
“Finding the balance between fear and greed…”
According to prominent, and successful, traders one of the primary tasks of every trader is risk management. Some even say that traders are basically risk managers with a bit of an interest in financial markets. Although that might be an exaggeration, it is undeniable that even traders with brilliant performance records might end up losing money without a proper a risk management strategy.
How is that possible?
For starters, trading always has an element of uncertainty, as no one can possibly foresee future events that might affect the price of the traded asset. But predicting the future is not the goal of trading in the first place. Predicting the probabilities of future price movements is the real goal of a trader, and this leads to the conclusion that you don’t trade because you are sure of what is going to happen.
With that in mind, it is easy to see that you have to prepare yourself for losses, even with the most successful and reliable strategies. This means that you have to have a risk-management strategy before you start trading and entering positions.
Before looking into the development of your trading plan, here is a list of the most important risk management techniques for traders:
- Position Sizing
- Stop-Loss and Take-Profit orders
- Special day-trading techniques: Loss limits and “circuit-breakers”
As you will see, all of these tools require a high level of discipline to follow, as they significantly limit your options during trading. Your ego will try to take control over your trading from time to time. Taking a loss, for example, is more painful than a non-trader could imagine; this leads to cancelled stop-loss orders, and in turn an ignored risk-management plan. But almost all of these tools might be compromised by your fear and/or greed, the two basic emotions that endanger your trading performance.
Psychological risk is possibly the most neglected risk in trading and it also one of the hardest to manage. We will show you techniques to deal with it, but first, let’s get started with the all-important trading plan!
Developing a trading plan
Managing your risks starts with a well designed and executed trading-plan. This plan is not necessarily complex, but here are some basic questions that you always have to answer before entering a trade:
- How does the trade fit into your portfolio?
- What is the time-frame of the trade?
- What position size should you choose?
- What is the maximum loss that you are willing to take?
- What is the potential of the trade?
We won’t get into details regarding all of these questions now, but to answer them, you will require some essential risk-management tools like position sizing and diversification. We will begin with these methods.
The most common mistake among new traders is taking dangerously large positions. Why? Because traders usually use their own profit targets, $50 a day, as the foundation of their trading strategy. There is nothing wrong with having a daily profit target, but it has to be in line with the amount of capital that you have, as the $50 will almost certainly lead to serious problems with a $500 account, but could be optimal for a trader with $10,000 in trading capital. So, you have to think in exactly the opposite direction. Your profit target won’t be decided by you; rather it will be determined by the amount of your capital
When deciding on the optimal position size, your primary input should be the size of your account. The second important thing is to determine the loss that you are comfortable with. From these two factors, you can roughly calculate your optimal position size (the exact size will depend on your actual strategy) for every asset, together with a realistic daily/weekly/monthly profit target.
“Ok, but what should be the maximum loss?” you might ask. Well, that depends on your own tolerance level and, to a certain degree, your strategies. An “average” trader should target a few percent (a lot of traders use a 2% limit) of her/his portfolio per trade. That’s right if you have a small account you will have to trade small, probably much smaller than you would have thought.
Beginner traders usually have small accounts, but they are also eager to trade and make money. This has a lot to do with some of the sobering statistics about the ratio of successful traders. But don’t worry, if you follow this first, and most important risk management tool, you will have a great chance of success.
Diversification is the elaboration of the old saying that you shouldn’t hold all your eggs in one basket. This means that by risking everything on one position, instead of several positions, you are much more exposed to an unforeseen event. This makes sense intuitively, but there is a catch when dealing with forex markets.
The catch is called correlation and it means that a lot of currency crosses tend to move in tandem, meaning that even if you have more than one position, your exposure might be higher than you think. It’s easy to see that if you have long positions in pairs that include the same currency (such as the Aussie in the case of AUD/USD. AUD/JPY, and AUD/NZD), you will be very much dependent on the performance of the Australian Dollar, but there less obvious, but sometimes equally strong correlations between seemingly unconnected pairs.
That said, correlations are usually not perfect, so you will have a level of diversification even with closely linked pairs. In order to minimize correlation-risk, it is wise to do some research (most platforms have a list of correlations) before entering positions in multiple pairs of the same currency or in highly correlated pairs.
Stop-Loss and Take-Profit orders
“There is always another trade…”
After position sizing the most useful way of preserving your capital and limiting your losses is to use stop-loss and take-profit orders. These orders will automatically cut your losses if a trade goes sideways, and protect all or part of your profits if a certain price target is reached.
As an example for simple Stop-Loss and Take-Profit orders, if you enter a long position in the AUD/USD pair at 0.75, you might enter a Stop-Loss order to 0.745 and a take-profit order at 0.76. This means that your maximum loss will be 50 pips and you will automatically exit the position if your profits reach 100 pips.
There are more advanced versions of these orders such as partial Take-Profit orders with multiple price targets, and trailing Stop-Loss orders that “follow” the price if the market moves in your favor. Demo accounts are great for experimenting with different order types and risk-management strategies. Be sure to try out how they work if you have any doubts about them!
Hedging is a less popular way of managing risks in forex markets that is mainly applied by equity and commodity traders. This method involves the use of derivatives (such as options or futures options),
which are financial assets that are linked to the movements of the price of an underlying asset. Without going into details, these derivatives can serve as insurance policies against excessive moves in the asset that you trade with.
If your broker offers forex options, it might be better suited for limiting your losses than Stop-Loss orders in some special cases. In volatile markets or less liquid pairs, Stop-Loss orders might get executed at unfavorable prices compared to your pre-defined levels. Why? Well, sometimes there is simply no one standing on the “other side” of the market to take your order, so it will be executed at the best available price. Also, hedging can protect you from events that happen when the market is closed. Stop-Loss orders are useless in these cases as the price can simply jump over your stop-level (this is called a gap by traders), causing possible heavy losses.
Special day-trading techniques: daily loss limits and “circuit-breakers”
There are special methods for the most active traders, who execute multiple trades a day. Day-traders are even more exposed to the psychological risks of trading, especially negative streaks, as the emotional stress of multiple losing trades (that happens even with the best of traders) can lead to reckless decisions. On the other hand, winning streaks can make day-trading a very lucrative endeavor, so let’s see some ways to effectively prepare yourself for the inevitable “bad times”.
The best method of avoiding losing streaks is to simply stop trading when you reach a daily limit or a “circuit-breaker”, such as a limit of 4 losing trades in a row. A more subtle method is to reduce the size of your positions when in a losing streak and increase your size as you start winning again. When used properly, these tools are very effective, but remember that day-trading requires some level of experience, and it is not recommended to start your career with such an intensive trading style.
Trading starts with and risk management. Those traders who understand this have a much better chance of success than those who “blindly” start trading. The essential methods that we have discussed cover the biggest risks that you will face, and if you combine them with proper strategies, you will be ready to start a successful trading career!