Forex Risk Management | Tools to Manage Forex Risk
As online trading has flourished, forex brokers have realized that they have gained access to a new market in itself – retail (trading). The more the internet penetrates all corners of the world, the more people come to trade in the largest market in the world – foreign exchange.
Foreign exchange, or forex for short, used to be an exclusive marketplace to buy and sell currencies, where only large institutions and high net worth investors in the industry had access. With a minimum transaction of 2-5 million dollars, names like Deutsche Bank as well as other investment enterprises like mutual funds, hedge funds etc, bought and sold currencies to one another based on their needs. This interbank market still exists today and forms the basis of what everyone knows as the Forex market.
After the Bretton Woods agreement in 1944, the United States pledged to exchange US Dollars into gold, effectively setting the ‘gold standard’ (for currencies). Other countries followed suit, but in 1971 the Nixon administration dropped this pledge. It was the birth of free-floating currencies and is what we know as the Forex market today.
Forex brokers allow retail traders to take part in this market, in exchange for a commission or fee (e.g., spread). Due to online trading and the leverage provided by these brokers, the average trader can ‘stand at the same table’ with the big names in the industry.
Despite the size of the retail market, it is relatively small compared to the overall currency market as a whole. Even so, retail is less than 6% of the daily turnover in FX trading.
This means the larger institutions make up the real volume and dictate the state of play. Retail traders must adapt their strategies to survive the extreme volatility that can follow. Risk management, therefore, is critical for successful long-term trading.
Best Strategies to Forex Risk Management
Let’s put some numbers behind the FX market. The daily turnover is somewhere around $5 trillion dollars and rising. As stated above, 5-6% of this is comprised of retail traders. The rest is made up of a variety of hedge funds of, high-frequency trading firms, ‘quants’, etc, including central banks who need to conduct their operations in things like managing reserves for example, and other matters relating monetary policy.
It is little wonder retail traders stand little (limited?) chance of survival as their flow does little to affect prices. Hence, they must adapt and become followers (effectively), aligning their interest with the other market players.
A quick look at some statistics related to the retail segment shows a dark picture. Over 90% of traders lose their first deposit. Out of those, less than half come back to give it another try. From this last batch, about half end up trading on a longer-term basis with some, eventually, concentrating on this as a primary source of income.
Trading for a living naturally means mastering the ‘art of speculation’. Either through scalping (trading for the short-term, hunting quick changes in prices) or investing (keeping positions longer, harnessing the power of trends), all retail traders need to speculate.
Traders (in essence) bet on the direction of a currency/currency pair and as such have ‘skin in the game’. Everyone knows (or should know) that their money is at risk, but this is the world of investing and gaining success is a blend of the right trading strategies as well as discipline through money management.
Armed with information on the probability of survival, serious retail traders learn how to use effective forex risk management. There are many tools to manage forex risk, and we will cover the most important ones in this article.
Foreign Exchange Risk Management Definition
In principle, forex risk management refers to the amount risked per trade. This concept is not that simple. It depends on many factors like the leverage used in the trading account, the stop-loss and take-profit levels, risk-reward ratios, trader psychology, and so on. Using specific forex risk management tools, traders control the evolution of their trading account so that it grows in time.
The reason why retail traders come to the forex market is, naturally, to make a profit. Most traders have a day job and just want to supplement their income by putting their money to use. This can be a blessing – or a curse!
It is a blessing if you do not depend on the money (hopefully) made from trading. However, there is a risk that it can be treated as a ‘as a hobby’ and this can quickly lead to extended losses.
As stated above, most retail traders lose their first deposit when embarking on te world of trading. It is fair to say that it is likely that the approach is wrong. Instead of focusing solely on how much money to make, why not concentrate as much effort on managing the risk of potential loss
Therefore, the right approach to successful trading should be to protect your deposit, and only after that, focus on maximizing profit potential.
Diversification as Part of Forex Risk Management
As the old saying goes – don’t put all your eggs into one basket. In other words, diversification avoids this is the first mistake in managing risk.
Forex risk management starts, therefore, by diversifying your trading account. Diversification splits risk, though traders must also carefully consider avoiding over-diversification.
There is a delicate balance between how much to diversify. Beyond a certain point, diversification can end up neutralizing the trading account and limiting growth. Diversification starts with cash. Cash is king. Make sure there is always a cash position available in the trading account.
Cash fulfills multiple roles as a forex risk management tool. First, it provides the much-needed margin when trades move against you. Second, it can give you the opportunity to profit from unexpected “gift” the market sometime serves up. Think of a great opportunity to trade, but you have no margin left to take the trade. That is called an opportunity cost and traders should avoid this by maintaining a cash balance at all times. Around 15% of the funds deposited should remain in cash, ideally 20%.
Due to stiff competition, forex brokers nowadays offer access to a range of markets. Traders can buy or sell individual equities or indices, commodities such as gold, silver, and oil, as well as bonds. Other financial products are also offered such as Cryptocurrencies – and all from the same trading account!
This can lead to a temptation to trade a market just because it is available and active. However, overtrading can be disruptive to your account and should be avoided, again through diversification or splitting risk.
Imagine building a forex risk management chart, much like a pie chart, and allocating resources from the trading account. The breakdown could be 20% in cash, 40% for trading currencies, 20% for commodities and the rest for trading individual stocks and indices via CFDs (Contracts for Difference). Following this simple rule gives you structure and a greater chance for the account to survive in the long run and to profit from all market volatility.
The One Percent Rule – One of the Tools to Manage Forex Risk
Risk management is and must be applied to all markets not just Forex.
Now that diversification is identified, it is time to focus on each trade. One simple rule is enough to make sure traders do not ‘blow’ their account -. The One Percent rule.
The One Percent rule states that traders should not risk more than 1% of their limit on any given trade. No matter what!
Moreover, the One Percent rule does not apply to the balance of a trading account, but to the equity within it. The equity is responsible for showing the accurate state of the trading account at any point in time.
Why 1% and not 10%. It is down to statistics. When using the One Percent rule, even a 72 consecutive losing streak won’t result in losing the trading account.
Instead, such a terrible run would end up only wiping only 50% of the account. That said if a trader achieves such a performance rate, perhaps trading the financial markets isn’t for this person. The right thing to do in this instance would be to take the balance of monies and do something else with it. One could invest in learning how to trade perhaps, or do something completely different.
In any case, the One Percent rule helps a trader avoid becoming part of an infamous statistic (90%) of traders losing their first deposit. The One Percent rule is a forex risk management tool that keeps potential losses at bay.
Forex Risk Management Calculator – Transforming Pips Into Percentages
The next thing to do is to transform the One Percent ‘risk’ on any given trade into an actual stop-loss order. It all equates to the number of pips being risked.
A pip refers to the fourth digit in a quotation for most of the major currency pairs. For instance, if the EURUSD moved to the upside from 1.15413 to 1.15628, this means the market has moved 21.5 pips higher. The value of a pip relates to the size of the contract or volume traded.
The stop-loss order is one of the key tools to manage forex risk. Every trade should involve a stop-loss and a take-profit level. Both of them relate to the number of pips risked, and the number of pips forecast to make a profit.
In a $1000 trading account, using one lot per trade makes little sense if a single pip is worth $10. This would mean a 10 pip move against the entry price would wipe out 10% of the trading account.
Remember the One Percent rule? It makes sure you will never extend beyond the volume limits of the account. Instead, the key is to start from the number of pips needed for the stop-loss order. Any trading strategy begins with a validation or invalidation level – whichever way you look at it – or in other words, what would make the trade idea viable.
The stop-loss order is never the same regarding the number of pips needed. However, it must have the same risk: one percent. The idea is to adjust the volume for every trade in such a way as to make sure the number of pips needed for the stop-loss order won’t affect the trading account more than one percent of equity. Hence, if the market does go against your position, based on this rule, the loss is only 1%.
Internal and External Techniques of Risk Management
Now that the risk is managed by the One Percent rule, how about focusing on the reward aspect? One of the internal tools to manage forex risk deals with using appropriate risk-reward ratios. As a rule, the reward should always exceed the risk by a factor of at 2:1.
Effectively, this means that for every pip risked, you expect to gain a minimum of two. Converting it into percentages, if the risk is 1% as per the rule mentioned above, the expectations are that reward is minimum of 2%.
Naturally, the higher the ratio, the better for the prospects for the trading account, as it increases the chances exponentially to survive (and thrive) in the long run. However, traders also consider external factors that affect the forex risk management in a trading account. More precisely, correlations jeopardize an account visibly.
Correlations have the power to invalidate the one percent rule. When trading correlated assets, taking two trades on different currency pairs or markets, means risking 2% instead of only 1%. Hence, forex risk management strategy is affected.
The first thing to consider is the USD. As the world’s reserve currency, the American Dollar is responsible for most of the volatility in the FX market.
It splits the currency pairs into majors (ones with USD in their component) and crosses (without the USD), with the majors expected to move in a correlated manner most of the time.
Other correlations to note include USD?CAD and the price of oil, as Canada is a large producer of Oil. USDJPY is correlated with US stocks like the DJIA (Dow Jones Industrial Average) as a general risk trade. These are just to name a few as there are many others.
Don’t Let Potential Losses Affect You – Losing Is Normal
Perhaps the most critical aspect of trading is how to deal with the emotional rollercoaster. Knowing that you stand to lose (1%) is a comfortable way to deal with a loss. Start with the understanding that losing is just as likely to happen as not.
Markets are so complex and can move so fast that no one can win all the time. Even the best of traders lose at times. This is why accepting losses is an important part of the trading psyche. Next, focus on maintaining a risk-reward ratio above 1:2. Finally, avoid correlated markets.
The lack of forex risk management is responsible for the dreadful statistics we have mentioned in this article. Applying the tools to manage forex risk explained in this article, exponentially increase the chances of successful trading.
Just as in battle, trading is all about the tactics and strategies used. Only those who are best-prepared will survive!