What Is Risk Management in Forex Trading? How to Calculate Risk

What Is Risk Management in Forex Trading? How to Calculate Risk

Forex trading can be a roller coaster ride for unprepared investors. But, like any other form of investment, if you have strategies in place, you could even get to turn your forex dealing into a full-time career.

One major area any forex trader needs to find out about when they learn to trade is the significance of risk management, and this is discussed in more detail below.

What is risk management in Forex Trading?

What Is Risk Management in Forex Trading? How to Calculate Risk
Risk Management is the most important in Forex but mostly ignored and misunderstood by traders. A beautiful trading system cannot imagine without proper risk management. Your first job as a trader is to manage risk.

Larry Benedict: “You are not a trader; you are a risk manager.”

The world economy is very much uncertain, we cannot perfectly predict what is going to happen. All we can do is forecast, assume, and observe. We should continuously look for favorable situations for entering a trade. Even though everything may seem perfect, the market can react opposite due to many factors. So, to survive for a longer time and save our investments we must have a good risk management system that aligns with our trading plan and our trading behavior. Once we fixed our risk percentage, we must not vary or change with time.

Its recognised that up to 90% of new forex traders lose cash on their first trades and many of them will give up trading at this point.

But, forex is a massive global financial market and over $5tn is traded on exchanges on a daily basis. Traders can be active on the forex market 24 hours daily, and, whats more, you dont need to invest pots of your own cash into trading.

Plus, online forex broker commissions are competitive, making it easier to see profits from regular trades.

One of the most important learning curves for newbie forex traders is risk management, though.

Leverage in forex trades can be as much as 1000:1, meaning that for every £1 you invest into a trade your broker will add leverage of 1,000 x, so you can trade £1,000 worth of currency with your £1. Of course, different brokers work to their own rules on leverage and the current allowable amount in the UK and EU regulators state that major forex currency pairs should only be allowed 30:1 leverage. While less popular currency pairings can be leveraged up to 20:1.

Leverage allows you to invest more cash into your forex currency trades, potentially offering greater profits. However, the risks are greater. If your chosen currency loses against the paired currency you will need to cover all losses made in the trade. Thats why its important to plan your risk management strategy in advance for all forex trades.

People also read: The Ultimate Guide to Building a Forex Trading Plan

How to calculate risk on Forex?

What Is Risk Management in Forex Trading? How to Calculate Risk
Lot size, SL, TP and Risk: Reward calculation according to risk management:

Example 1:
Suppose 100$ balance and 2% risk. 2% risk per trade= 2$
Pip value: for 0.01 lot= 0.1$. So, Risk amount/pipvalue= pip (SL)
2/0.1= 20 pip, Standard R:R = 1:2
Then, Sl= 20 pips and TP= 40 pips
So if we lose we will lose 20*0.1= 2$ and if we win we will gain 40*0.1= 4$.
Now if, SL=10 pips and risk is still 2% and same R: R ratio,
We can use lot size= 0.02
So, Risk= 10*0.1*2= 2$.

How to determine the percentage of trade to be profitable?

Suppose according to the same above example we took 10 trades and calculate 2 scenarios.

Scenario 1: 3 won and 7 losing trades.
Winning trades= 3*4=12$, Losing trades= 7*2= 14$
So Gain= -2$
Scenario 2: 4 won and 6 losing trades.
Winning trades= 4*4=16$, Losing trades= 6*2= 12$
So Gain= 4$

Finally, in this risk management system, we need at least a 40%-win rate to have positive growth.

Example 2:
Lot size and SL calculation
Assume 500$ account and 5% risk.
So, 500*0.05= 25$
0.01 lot SL= 25/0.1= 250 pips
0.05 lot SL= 25/0.5= 50 pips
0.1 lot SL= 25/1= 25 pips
0.2 lot SL= 25/2= 12.5 or 13 pips
So, Risk amount/pip value= SL distance in pips

Sometimes we get SL distance from measured objectives, From predetermined SL we can calculate lot size from pip value. Then, Risk amount/SL distance= pip value

Suppose 50 pip measured objective
Pip value= 25/50= 0.5,
So the lot is 0.05

Managing your Risk in Forex Trading

What Is Risk Management in Forex Trading? How to Calculate Risk

As can be seen, managing risks in forex trading can be the difference between losing a fairly large sum on your first trade or regular profitability over a longer term. When you manage forex trading risks effectively you will probably never be in the situation of losing all your cash.

Our tips on effective risk management include:

  • Monitoring position sizes - Work out what percentage of your funding will be used for any trade and stick to it. So, if you have a £10,000 trading account balance (including any leverage), you may want to limit your risk by 1% or 0.5% per trade. This means you would risk a loss of £100 or £50 per trade. The other risk factor to consider is your pip risk, meaning you need to set a stop loss order at the most appropriate point.
  • Stop losses - You can find out more about pips in forex trading in our knowledge base. Placing a stop loss order means the trade will close out after a specified total loss. You need to work out how many pips you are prepared to risk on any trade, ideally, this should be as close to your entry point as possible.
  • Take profits - Another common mistake made by new forex traders is failing to recognise the point at which to take profits. There are strategies you can use to manage the point at which to take profits. Probably the most solution for newbie traders is to put a close position order in place to take profits at the appropriate level of resistance. Candlestick recognition and moving average crossovers are some of the other strategies used by traders, and you can find out more on our site.
  • Having a trading plan - From all the above, you can see its vital to have a trading plan in place for forex deals. Its important you dont rush into trading and perhaps risk 10% of your capital on one trade, 20% on another and so on. Because this is the way to lose all your trading capital in just a few losing trades.
  • Staying disciplined - Put discipline in place with all your forex trades, this way you can build your capital slowly but surely. You may not make thousands in a couple of days, but equally, you wont lose thousands either!
Always expect the unexpected from the market. Statistically improbable events occur far more often than they theoretically should.

Mark cook: “The main thing is that every trader has to be honest about his or her weakness and deal with it. If you can’t learn to do that you will not survive as a trader.”

“Being wrong is acceptable but staying wrong is totally unacceptable.”

Good traders have humility. They have the ability to admit when things are not going their way and make a new decision. They know that part of trading is being wrong.

Dont miss: How Much Money Can You Make Trading Forex?

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