Did you know that measuring and managing the risk exposure of your trading account is the most important aspect of successful trading?
Risk management is vital for reducing your account vulnerabilities against significant fluctuations, which could adversely affect profit margins and your account.
Not understanding your risk style and general risk concept could make a direct loss to your account, so it is vital to understand it. This article is here to help.
Forex Trading Risks
As in any market, there are various types of risks. You should be aware of any risks before you start trading as it could significantly enhance your profit factor. Knowing how to deal with risks will make you stand out from the losing crowd.
For people outside of the Forex world, a standard definition of exchange rate risk is related to the effect of some unexpected exchange rate change in the value of the currency pair or the currency itself alone.
Within the word of Forex trading, you will encounter three types of risks:
- Economic risk
- Transaction risk
- Operational risk
Economic risk reflects the risk to the currency exchange rate due to various economic factors. News and data releases from all parts of the world affect the markets in different ways.
If you don’t follow the economic calendar, that means – you are not prepared. There are tons of reports, but understanding which one is crucial is the hardest part.
Transaction risk represents the use of leverage, stop loss, correct strategy, and general volatility.
Correct use of leverage and stop loss will ultimately determine your trading profit potential. Analyzing the price and having a good strategy is not enough if you trade with substantial risk margins. Remember, if you cross 3% of your risk threshold, then you will be technically trading high risk. Anything between 5 and 10% is considered ultra risk bordering gambling.
The goal is to find the optimal balance between leverage and risk. The best compromise is to be in a position where are you are leveraged to the max as long as your account is within your risk tolerance. I never suggest more than 5 % of overall risk per day.
Operational risk is a technical risk and broker’s risk. You need to have your platform up and running while being operational at all times. Your PC or Mac should be strong enough not to freeze and lag, while at the same time your internet is working fast and properly.
Traders should strive to maintain backups in case of a blackout. However, in the case you want to monitor your trade progress and manage it, it is always good to have MT4 Android or iPhone at your disposal. All brokers face operational risks as they conduct their daily services and activities. They usually have well established internal procedures, organizational structure, technology, liquidity processes to ensure business continuity.
Your broker should always ensure maximum client protection and comfort during trading.
Understand the Risks in a Proper Way
“Trading using leverage carries a high degree of risk to your capital, and it is possible to lose more than your initial investment. Only speculate with money you can afford to lose.”
This is crucial to understand. High leverage usually equals high risk because you can theoretically lose more than the money you deposited in your account.
Don’t forget that brokers have automatic systems in place to force liquidation of your position before the leverage make you lose more than 100% of your account.
You’re still liable in the event of a problem occurring during the liquidation process, and your account goes into debt, hence the high risk of losing more than what you put into the account. That is why it is essential to use a broker with negative balance protection.
There’s nothing wrong with leverage if you manage risk correctly and use it wisely.
The biggest problem that could arise when there are volatility and emotions start to affect you, as such, usually, such high leverage will cause emotional errors that will quickly escalate to magnified losses.
Determining your Risk Tolerance
Determining your risk tolerance involves several different things.
First, you need to know how much money you have to invest and what your investment and financial goals are.
For instance, if you plan to retire soon, e.g. in ten years, and you’ve not saved a single penny towards that end, then you might consider embracing a high-risk tolerance approach (if your style is suitable for that) – because you would need to do some aggressive – risky – investing to reach your financial goals.
On the other hand, if you are at the start of investing for your elderly days or your retirement, obviously your risk tolerance can be low(er).
Secondly, when you start trading, you will be presented with various options:
- Account type
- Desired leverage
- Available currencies that you deposit your account with
That is what I call the “package”.
The various types of accounts offered by brokers can be confusing at first, so be sure to check all the account types as it can shape up your strategies.
- If you have a good understanding of leverage and trading in general, you can be satisfied with a standard account.
- If you’re a complete beginner, you should make use of a mini account. Generally start conservatively, especially at the beginning of your career.
I use different accounts with different strategies. I can afford to trade with a margin if I am about to build my account up. However, if I already have a prominent account, I will be a bit more conservative.
Raise Up Your Account Organically
Begin with small sums, and low leverage, while adding the profits to your account. Compounding can be an excellent way to boost your profits up exponentially but only if you are able to follow it religiously. A larger account does not necessarily mean higher profits.
If you can increase the size of your account through your trading, great. If not, there’s no point to burning cash in the Forex furnace.
Start Low and End Up High
To limit the risk on every trade you make, your trades should start within between 0.5% and 3% of your account balance with overall risk exposure to a maximum 5 % per day. You should base your risk on your performance, but due to reasons that I stated at the beginning of the article, it is better to start your day with less risk.
That way you can make more trades (while still being under the risk limit) and eventually end your day (or week) in a profit.
Cheers and trade safe,