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Risk Management
Risk management is the ability to minimize loss and maximize profit. The key to Forex trading is proper risk management. Risk management is the heart beat of Forex trading. Your level of knowledge on risk management determines your altitude in your forex career. That is why forex experts and analyst will advise, do not risk more than you can afford to lose. To avoid unnecessary loss, use sound risk to reward ratio management system.
Risk management is the ability to minimize loss and maximize profit. The key to Forex trading is proper risk management. Risk management is the heart beat of Forex trading. Your level of knowledge on risk management determines your altitude in your forex career. That is why forex experts and analyst will advise, do not risk more than you can afford to lose. To avoid unnecessary loss, use sound risk to reward ratio management system.
Risk to reward ratio is the amount of money you are willing to loss (risk) and the amount you are willing to gain (reward). To be on the safe side, risk minimum of 1 % of your deposit on a single position and maximum of 5% on the overall positions. But for me, I make use of minimum 1 % of my deposit on a single position and maximum 2% on the overall positions. Due to the volatility and unpredictable nature of the market, I always recommend Nano lot size for account holders less than $1,000 and micro lot size for account holders between 1,000-$3,000. Why? Because lot size, is the brain box behind risk management system which determines your success in forex trading if properly understood and managed.
Speaking of risk to reward ratio, there are different risk to reward ratio system out there, but, I will recommend a risk to reward ratio of 1:2, until you are familiar with it, only then you can go for 1:3 or 1:4 and so on, as it pleases you. A risk to reward ratio of 1:2 simply means gaining twice of your loss. Since risk management is tied to lot size, therefore, lot size cannot be overemphasized. But we are going to look at lot size and pips together, because they are the basic principles of forex trading and risk management system. Now, the questions are what is lot a size? And what is are pips?
Lot size
Lot size is the volume of an asset a trader use to execute an order.
Lot size is divided into four basic categories viz: Nano lot, Micro lot, Mini lot and Standard lot size.
1 Nano lot is 100 units, which is equivalent to $0.01
1 Micro lot is 1000 units, which is equivalent $0.1
1 Mini lot is 10,000 units, which is equivalent $1 and
1 Standard lot is100,000 units which is equivalent $10
Pips is an abbreviation of (Percentage in Points)
Pips are the unit of measurement use to express the change in value between two currencies.
1 pip of 1 Nano lot is equivalent to $0.01
1 pip of 1 micro lot is equivalent to $0.1
1 pip of 1 mini lot is equivalent to $1 and
1 pip of 1 standard lot is equivalent to $10
Lot size
Lot size is the volume of an asset a trader use to execute an order.
Lot size is divided into four basic categories viz: Nano lot, Micro lot, Mini lot and Standard lot size.
1 Nano lot is 100 units, which is equivalent to $0.01
1 Micro lot is 1000 units, which is equivalent $0.1
1 Mini lot is 10,000 units, which is equivalent $1 and
1 Standard lot is100,000 units which is equivalent $10
Pips is an abbreviation of (Percentage in Points)
Pips are the unit of measurement use to express the change in value between two currencies.
1 pip of 1 Nano lot is equivalent to $0.01
1 pip of 1 micro lot is equivalent to $0.1
1 pip of 1 mini lot is equivalent to $1 and
1 pip of 1 standard lot is equivalent to $10
Note:
1 pip of 1 micro lot is $0.10
5 pips of 1 micro lot is equivalent to $0.50
100 pips of 5 micro lot is equal to $50
50 pips of 1 mini lot equal to $50
20 pips of 2 standard lot is equal to $400
5 pips of 1 micro lot is equivalent to $0.50
100 pips of 5 micro lot is equal to $50
50 pips of 1 mini lot equal to $50
20 pips of 2 standard lot is equal to $400
Trader A can decide to use little lot size and large number of pips to achieve same result as trader B with large lot size and little number pips. For example, if trader A buys EURUSD with 4 micro lot and made a profit of 200 pips, his gain will be 4 micro lot multiply 200 pips which is equivalent to a profit of $80.
If trader B buys same EURUSD with 1 standard lot and made a profit of 8 pips, his gain or profit will be $80 as well.
If trader B buys same EURUSD with 1 standard lot and made a profit of 8 pips, his gain or profit will be $80 as well.
How Risk management, Pips and Lot Size operates
Like I said initially, forex experts and analyst will advise: do not risk more than you can afford to lose. To be on the safe side, risk minimum of 1 % of your deposit on a single position and maximum of 5% on the overall positions. To calculate your risk (the money you are willing to lose), you multiply your margin by your risk % and for reward (the money you are willing to gain) you multiply the margin by your reward %.
Like I said initially, forex experts and analyst will advise: do not risk more than you can afford to lose. To be on the safe side, risk minimum of 1 % of your deposit on a single position and maximum of 5% on the overall positions. To calculate your risk (the money you are willing to lose), you multiply your margin by your risk % and for reward (the money you are willing to gain) you multiply the margin by your reward %.
Assuming my margin is $1,000 and I sold GBPUSD of one micro lot. To calculate a risk of 1% of my margin, I shall multiply the risk of 1 % by my margin. I.e. $1,000 times 1% which is equal to $10. Remember, forex trading operates with lot size and pips to enable you get the actual risk to reward ratio you desire. To get the actual number of pips, you divide the risk or reward by the lots size. Therefore, from the sell order of GBPUSD of one micro lot, of my $10 risk, I shall get 100 pips.
Note:
The higher the pips the lower the lot size and the lower the lot size the higher the pips vise - visa. Always calculate your loss before your profit not, only but also use an appropriate lot size and reasonable number of pips to execute a trade.
With reference to our margin, risk, reward and lot size, if a trader decides to operate with risk management system of 1:2 risk to reward ratio, it therefore means that, for every 100 pips loss, the trader makes 200 pips gain. Good risk management system helps a trader to curb unnecessary loss that is the main reason he must be disciplined and stick to a suitable risk management system that is profitable to him.
Below are my six tips for risk management system:
- Educate yourself about Forex trading risk
- Do not risk more than you can afford to lose
- Use stop loss and take profit to secure yourself during trading
- Control your emotions
- Have a Forex trading plan
- diversify your forex portfolio
Educate Yourself about Forex Trading Risk
Whether new or experienced to trading, you need to educate yourself as much as possible. There is always a new lesson to be learned! Keep reading and continue to educate yourself on Forex related articles.
Do Not Risk More Than You Can Afford to Lose
One of the basic rules of risk management in Forex trading is that you should never risk more than you can afford to lose. Despite its fundamentality, making the mistake of breaking this rule is extremely common, especially among those new to Forex trading. The forex market is highly unpredictable, traders who risk more than they can actually afford, make themselves very vulnerable. The reason a trader should calculate the risk involved in Forex trading before he starts trading is because, some loses are enough to wipe out your trading capital. If the chances of profit are lower in comparison to the loss, then trader should stop trading.
Use Stop Loss and Take Profit to Secure Yourself during trading
A stop loss can protect you against great loss. Stop loss is a tool that allows you to protect your trades from unexpected market movements by letting you set a predefined price at which your trade will automatically close itself. Therefore, if you enter a position in the market in the hope the asset will increase in value, and it actually decreases, when the asset hits your stop loss price, the trade will automatically close itself to prevent further loss. While take profit is designed to automatically close trades once they hit their profit target. By having clear expectations for each trade, not only can you set a profit target, and therefore, a take profit, but you can also decide an appropriate level of risk for each trade. Most traders would aim for at least a 1:2 risk to reward ratio, where the expected reward is twice the risk they are willing to take on a trade.
Control Your Emotions
There are many common principles in trading psychology and risk management. Forex traders need to be able to control their emotions. If you cannot control your emotions whilst trading, you will not be able to reach a position where you can achieve the profits you want from trading.
There are many common principles in trading psychology and risk management. Forex traders need to be able to control their emotions. If you cannot control your emotions whilst trading, you will not be able to reach a position where you can achieve the profits you want from trading.
Emotional traders struggle to stick to trading rules and strategies. Stubborn traders will not exit losing trades early on time, because they expect the market to turn in their favor. When a trader realizes his mistake, he needs to leave the market, therefore, taking the smallest loss possible. Waiting too long may cause the trader to end up losing a substantial amount of capital. Once the trader is out of trading, He needs to be patient and re-enter the market when a genuine opportunity presents itself.
Traders who are emotional following a loss also might make larger trades trying to recoup their loss by increasing their risk. The opposite may happen when a trader has a winning streak, they might get scared and stop following proper risk management rules. Do not become stressed in the trading process. The best Forex risk management strategies rely on traders avoiding stress.
Have a Forex Trading Plan
To properly manage your Forex risk, you need a trading plan that outlines at least the following:
- When to open a trade
- When to close a trade
- Minimum risk to reward ratio
- The percentage of your account you are willing to risk per trade
Once you have devised your Forex trading plan, stick to it in all situations. A trading plan will help you keep your emotions under control whilst trading and will also prevent you from over trading. With a plan, your entry and exit strategies are clearly defined and you will know when to take your gains or cut your loss without becoming fearful or feeling greedy. This approach will bring discipline into your trading, which is essential for good risk management.
Diversify Your Forex Portfolio
A classic, tried and tested risk management rule is not to put all your eggs in one basket, so to speak, and Forex is no exception. By having a diverse range of investments, you protect yourself in case one market drops, the drop will hopefully be compensated for other markets that are perhaps experiencing stronger performance. Another way you can expand you can expand your forex portfolio is to trade more than one currency pair.
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