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Understanding Forex Risk Management

The forex market is the most liquid and largest market in the world. However, like any other financial market, the forex market can also be risky during times of high volatility. Effective forex risk management can help traders mitigate their chances of losses and substantially improve profits. Let's take a look at how you can initiate risk management in trading forex:

What is Forex Risk Management?

Risk management is the process of identifying, analysing, accepting, and mitigating the uncertainty that comes with trading forex to minimise losses and maximise gains. It uses different strategies like setting stop-loss orders, leverage, and risk-reward ratio to protect traders against market risks and reversals. The goal is to measure trading risks and eliminate them before your trade is over. You can employ risk management techniques like placing stop-loss and limit orders, setting profit targets, and defining your risk tolerance.

What are the risks associated with forex trading?

Interest rate risk

Interest rate risks occur due to the changes in the interest rates of a country’s financial system, which can lead to fluctuation in a currency pair’s prices. The risk associated with fluctuating interest rates can be minimised by setting limits on your trading positions.

  • An increase in the interest rate of a country leads to an increase in the currency value of the same country and depreciates the value of the other currency against which the home currency is traded.
  • A decrease in the interest rate of a country leads to a decrease in the currency value of the same country and appreciates the value of the other currency against which the home currency is traded.

Exchange rate risk

Exchange rate risk is associated with the fluctuating values of currency pairs due to economic, social, political and financial reasons. When the forex market is volatile and witnesses a drastic increase or decrease in a currency pair's prices, it can lead the market to move against the trader. A sudden increase in exchange rate puts short traders at risk as they lose out on profiting from the falling markets and a sudden decrease in the same puts long traders at risk as they lose out on profiting from the rising markets. Exchange rate risks can be minimised by hedging by opening a trade in the opposite direction.

Leverage risk

Leverage refers to using borrowed money to invest in high value positions with smaller deposits. But it comes with its own risk, as any sl ight exchange rate movement can result in immediate losses if the trade moves against you. This means that if you buy a $1,000 position with 10% leverage, and the currency pair prices fall by more than 10%, it would result in you losing the entire trade value of $1,000. Forex leverage risk can be reduced by only taking as much leverage as you can afford to lose along with using trailing stop orders (an order that is only executed when the currency pair prices move favourably in your direction) to minimise losses.

Transactional risk

Transactional risk refers to errors associated with order completion, order delay, communication, order management, order execution and any other effect that the exchange rate may have on an open trade before it is settled. Transactional risk can result in losses due to human or machine errors. Since forex is traded 24 hours a day, the more time a trade is open, the higher the chance of a transactional risk occurring due to the gap in between the exchange rates at different points in time.

Settlement risk

Settlement risk refers to a situation when your bank carrying out the forex transaction pays for the currency pairs but you do not receive them in your trading account due to an operational problem or counterparty default. You can avoid settlement risks by analysing the brokers you deal with and choosing only financially sound counterparties.

Country risk

Country risk refers to all risks associated with a particular country whose currency you are trading. Each country's political stability, economic condition and financial health must be critically assessed before trading its currency to minimise country risk. A crisis in a country can occur due to a higher balance of payment deficit, financial crunch, and more that can devalue the country’s currency, leading to forex risk.

Liquidity risk

Liquidity risk refers to a situation when a trader cannot convert their existing currency pairs into cash due to a lack in the demand and supply of the same. Forex is a liquid market, but changes in government policy or a major news announcement can result in a period of illiquidity. The illiquidity can be avoided by trading currency pairs belonging to the largest, politically stable and economically sound world economies.

Fundamentals for risk management in forex trading

Risk appetite

Risk appetite refers to how much risk you (the trader) are willing and able to take to fulfil your trading objectives. Understanding your risk appetite is the first thing that needs to be done to devise a proper risk management strategy. Since currency pairs are volatile and witness several price fluctuations during the day, you should know how much amount you are comfortable losing. Your risk appetite depends on several things like your trading goals, objectives, available funds, financial strength and more, which differ from individual to individual.

Stop-loss orders

A stop-loss order is an order that you set to exit a trade if the market moves against you. It automatically closes the trade at a pre-decided price to minimise potential losses.

Trade size

Trade size or position size is the total number of currency pair units that you trade. Selecting the position size that fits your risk appetite and trading goals is important as it helps you protect against trading risks and maximise the chances of a successful trade. You can decide your trading position size by understanding your risk appetite, stop-loss order placements, cost of trading, and available funds.

Leverage

Since leverage amplifies your chances of maximising both profits and losses/risks, it is essential to manage it effectively. You should use a small amount of leverage to trade the currency pairs to limit your chances of risk that come with leverage trading, especially if you are a beginner trader.

Emotion control

One of the most important things in trading is to separate your emotions from your finances. When you are investing your money in the forex market, managing the emotions of trading helps you minimise trading risks. Greed, fear and excitement are some of the most common emotions traders feel while trading, which can impact their trading decisions. Weak emotional control also exposes you to significant risks, which is why taking your emotions out of the trading equations is important. Trading should be done objectively with the help of the right technical analysis, forex risk management strategies and indicators.

How to manage risk in forex

Use stop-loss and limit orders

Stop-loss and limit orders help execute automatic trade steps when a currency pair reaches close to the pre-decided price.

  • Stop-loss orders can get you out of a trade when the market moves against you.
  • Limit orders help you buy or sell a currency pair at the mentioned or better price.

For example, you can set a stop-loss order at a level that is 15% below the currency pair’s price at which you bought it to limit your loss to 15% of the total trade. So if the currency pair prices drop below 15% of its buying price, your trade will be automatically closed, and losses minimised.

Trade as much as you can afford to lose

It is a good practice to only trade money you can afford to lose entirely. This helps all traders, especially beginner traders, to invest effectively and avoid taking unnecessary risks just because they find the market exciting.

Decide on a risk-reward ratio

The risk-reward ratio calculates trading returns which in turn helps manage trading risks and capital. Setting a specific risk-reward ratio is vital as it helps assess the expected return from the trade and the risks. It is advised to set the risk-reward ratio at a minimum level of 1:2, which means that for every $1 expected risk, you expect a return of $2. So, you should aim to gain double of what you expect to lose from trading the currency pairs.

Understand currency correlations

Since forex is traded in pairs, you must understand how each currency is linked or correlated to another. When you are aware of how one currency’s price changes in relation to the other, you are able to better control your forex portfolio and reduce risks.

  • A currency pair is said to be positively correlated when a positive impact in one economy impacts the other economy positively.
  • A currency pair is said to be negatively correlated when a positive impact in one economy impacts the other economy negatively.

Avoid adding to losing trades

It is a common practice that traders add onto the falling currency pairs to average out the price in order to sell the currency pair later at a higher exchange rate. Traders should avoid adding to losing trades as that can result in higher losses. There is a possibility that the falling currency pairs keep on falling due to an expected downtrend which leads the traders to bigger losses compared to before.

Keep your position size and risk consistent

When you see your trades winning, it is common for you to assume that increasing your position size will amplify your profits. But this is not always the case. Increasing position size also increases trading risk, which can lead to you losing all your invested money if the market moves against you. Becoming overconfident while trading leads to you deviating from your trading strategy, which pulls you away from establishing a successful trading process.

Devise a Forex risk management strategy for successful trading

It is essential for you to formulate an FX risk management strategy before you begin trading to achieve your forex goals with minimum losses. You can start trading currency pairs on Blueberry Market’s forex trading platform in Australia by utilising the several trading techniques, tips, strategies and forex risk management tools available for a seamless trading process. Sign up for a live trading account or try a risk-free demo account on Blueberry Markets.

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