Forex Risk Management

Rule #1: Do not trade with the money you cannot afford to lose.

It is true that you cannot lose more than your initial deposit (your account capital) and the profit you may make is unlimited. However, it is possible that you could lose all your account capital if the market goes against you. You should never risk more than you can afford to lose.

Rule #2: Do not set out unrealistic goals like making a million dollars by the end of the month.

Don’t get carried away with the power of leverage. With a high leverage, it is possible to trade 100 times, 200 times, or even 400 times more than your account capital, depending on the forex broker of your choice. However, especially when you are just starting out and still learning how to trade, you should stick with a low leverage. Trade conservatively. A goal of 20-30% return on your initial investment during the first 6 months may be an admirable goal for most new traders.

  The following example illustrates the effects of leverage:

  To calculate the size of trade, use the general guideline:

So, for example, if your total account is $3,000, then $3000 x 5% (0.05) = 150. Then, divide the resultant by 50 (150 / 50 = 3). This gives you 3 maximum lots to trade at a time, with 2 lots traded at any one time.

When you enter a trade, it is probably best to start out with one lot. You can always add more lots later when you know for sure which way the market is moving. As you learn and gain more skills, you can gradually increase the number of lots to trade.

Rule #3: Use proper money management.

The primary purpose of money management is to preserve and protect a trading account against potential excessive losses. A good majority of a trader’s mistakes can be corrected, and losses can be compensated, if you use proper money management. Establish your own restrictions on the margin and volume of the contracts you trade. The restrictions will help you prevent from overtrading.

As a general rule, for a trade with the margin of 10%, you can trade just one full standard lot (100K) for each $10,000 of your account capital. If your account capital is smaller than $10,000, trade one mini 0.1 lot (10K) for each $1,000 of your account capital.

Rule #4: Avoid averaging like a plague!

When averaging, you open an additional position in the same direction as the existing losing position. Basically, averaging indicates that all the positions are open against the prevalent market movement and that a trader is still insisting on his wrong assumption even after the market movement has proven that it went against him.

Some of the common reasons why a trader participate in averaging are: greed, lack of experience, unwillingness or inability to recognize and accept their mistakes, naïve belief that the market comes back with a hope that the positions can be liquidated later at a break-even or maybe with a small profit. The reality is that averaging is one of the most dangerous trading techniques to use in real trading. Averaging can quickly lead to significant losses in a short period of time, and it is one of the most common causes for a trader to vanish from the forex trading after wiping out his account capital completely.

Rule #5: Always trade with a stop loss.

Decide where you will put your stop-loss and take-profit before opening a position. Do not trade with less than one-to-one risk/reward ratio. Look for the trades that give at least 1:1 risk-to-reward ratio, preferably 1:2 or 1:3 ratio. This way, even if you lose half of times, the total win is greater than the loss and your total account will grow bigger over time.

So, for example, if your target profit is 40 pips and set a stop loss of 20 pips, you have a 1:2 risk/reward ratio. If you apply this strategy, you can be right on the market direction only 50% of times and still make good profits.

  For more information, check out "Using Stop-Loss To Control Risks".

  See the "Limit Your Losses" section below for more information.

Rule #6: Practice before trading with real money.

Do not jump right into trading if you are new to forex trading. Most forex brokers offer a free practice account with play money. It is also recommended to practice on a demo account with the same leverage and the amount of money that you plan to deposit for your real account because the real effects of margin and leverage work very differently depending on the size of your capital account.

Rule #7: You must have a trading strategy.

Before you jump into forex trading, you need to have full understanding of the risks involved. As with any speculative investments, transactions of financial instruments " such as Stocks, Commodities, Indices, Gold, Silver or Crude Oil " can result in a substantial loss of money when the market doesn’t behave as you expected.

Forex trading is no exception. Because of leverage, there are real chances to win big with a small margin but, at the same time, there are also the risks of losing all of your margin. Just like any other speculative investments, amplified risks are always involved along with the probability for a huge profit/loss.

The enormous size of the forex market gives it the speed and liquidity like no other financial market. One can easily get caught in the excitement and thrills of winning and losing over a short period of time. When you get caught in the heat, your speculative investment could become more of a game of chance rather than calculated investing strategies.

Good traders know when to take a loss. They have the discipline to cut their losses and keep them small, and learn from the mistakes. Good traders always trade in a methodical and systematic way rather than relying on emotion or a must-win attitude.

  Click here to read about "How to Create a Winning Trading Strategy?"

  Click here to read about 400% Profit in 3 Days? How to Spot a Forex Scam . (Coming Soon)

Limit your losses.

To be successful in forex trading, you have to have a sound risk management plan with a disciplined trading strategy . In the previous section, you learned the importance of defining a proper risk/reward ratio. Once you’ve set it, you must stick to your strategy by utilizing stop-loss orders and limit orders. Limit orders let you stop and exit the trade at preset profit objectives. It also allows you to walk away from the computer without having to monitor the market all day. By utilizing limit orders and stop-loss orders, you will be able to maintain much more sanity and control even during a time of market turmoil.

Once you’ve set your limit order and stop-loss order on your trade, do not change them with one exception. The exception is when you know your trade is moving nicely in your favor and know that the market trend will most likely stay the same for a while, you could move your stop in your favor to maximize your profits. This will prevent your from exiting a winning trade prematurely.

Another technique you can use to maximize your profits when you are in a winning trade is a Trailing Stop. A trailing stop automatically moves up or down your stop-loss point according to the market movement. If your trade looks strong, you could move your stop-loss in your favor and continue to follow it with the trailing stop automatically.

Many forex brokers offer an effective safety feature called Margin Call against the potential risks of margin and leverage in forex trading. The margin can be monitored real-time and an email will be sent once the margin required becomes greater than 40% of equity for example. Should additional margin not be provided by you, all positions will be closed automatically as a safety measure. This will prevent customers from becoming indebted beyond their account capital.