Lesson 18. What is risk management?
Even if you have designed a really smart trading system, you can still fail on Forex without a sensible risk management strategy.
Risk management is a combination of multiple ideas to control the risk of losses. By limiting the risk you’ll make sure that you will be able to continue trading when things do not go as planned.
The constant use of the risk management is what constitutes the difference between an amateur and the professional trader.
So how can you limit your risk exposure? The basic rules are quite simple.
1. Don’t use too much leverage. Access to additional capital is great, but remember that leverage increases your losses if the market goes against you, so always make estimates of what you can afford.
2. Choose correct position size. It’s obvious that you shouldn’t put all your money on one trade. We’ll look deeper into the determination of optimal position size a bit later.
3. Limit the losses. Don’t neglect Stop Loss orders: they limit your losses and make the results of your trade more predictable.
Set these orders in the beginning and then don’t change them unless the market goes in your favor (in this case you can remove stop to breakeven point).
4. Always seek a bigger reward than the loss you are risking. This is called a “risk/reward ratio”.
If you risk losing the same number of pips as you hope to gain, then your risk/reward ratio is 1:1.
If you target a profit of 80 pips with a risk of 40 pips, then you have a 1:2 risk/reward ratio.
If you follow this simple rule, you can be right on the direction of only half of your trades and still make money because you will earn more profits on your winning trades than losses on your losing trades.
5. Be aware of currency correlations. Some currency pairs, for example, USD/JPY and USD/CHF, tend to move in the same direction or, in other words, have a direct correlation.
So, to have 2 positions in similar direction will double your risk exposure.
6. Keep track of your trades. Keep a diary to register and analyze your Forex transactions: this way you’ll manage your money more efficiently and will be able to learn on the history of your trades.