Risk management in forex

When we speak of forex risk management, we refer to the implementation of a set of measures and rules to guarantee that any negative impact of a forex trade remains manageable. An impactful strategy demands proper planning from start to finish. It is not a good idea to start trading and manage your risk as you go. Ad-hockery does not gel at all with risk management in forex.

Forex trading: risks

• Exchange rate risk

This is associated with changes to the prices for which you may buy or sell currencies. The isk climbs when you are exposed to global forex markets. Nevertheless, you can also be exposed obliquely thru commodities and shares ;

• Interest rate risk

This is the risk associated with the abrupt appreciation/depreciation of interest rates, which impacts volatility. Interest rate changes impact Forex prices since the level of spending and investment across an economy will go up or go down, taking into account rate change direction ;

• Liquidity risk

This is the risk that you cannot buy/sell an asset swiftly enough to preclude a loss. Granted that forex is by large a high liquidity market, there can be periods of illiquidity. This all depends on the currency and government policies around foreign exchange ;

• Leverage risk

This is the risk of magnified losses when margin trading. Since the initial outlay is less than the FX trade value, it is important to examine your capacity for putting an amount of capital at risk.

Risk management in forex: the how’s

The forex market is constituted of currencies from the world over. Forex is generally driven by supply and demand forces.

Forex trading works like any exchange where you are purchasing one asset using a currency. Regarding forex, a pair’s market price shows you how much of one currency you need to spend to purchase another.

The first currency in a forex pair quotation is called the ‘base currency’. The second is known as the quote currency. The chart-displayed price is always the quote currency. It stands for the amount of quote currency you will need to spend to buy one unit of the base currency.

Types of forex market:

The physical exchange of a currency pair occurs at the precise point the trade is settled;

• Forward market

A contract is agreed upon to buy/sell a set currency amount at a particular price, at a fixed date in the future or within a range of future dates;

• Futures market

A contract is agreed upon to buy/sell a set currency amount at a fixed future price and date. While forwards is not legally binding, a future is.

Risk management in forex: understanding leverage

You are trading on leverage when you use derivatives like rolling spot forex contracts while speculating on forex price movements. This permits you to get full market exposure for an initial deposit, called margin.

Suppose you decide to trade GBP/USD, and the pair is trading at 1.22485. There’s a buy price of 1.22490 and a sell price of 1.22480. You decide to buy a standard GBP/USD contract at 1.22490 since the pound is set to gain value against the US Dollar.

In this case, purchasing a single standard GBP/USD contract is the equivalent of trading GBP 100,000 for $122,490. You are set upon buying three contracts, giving you a total of $367,470(GBP 300,000). Nevertheless, since, in this case, the margin requirement for said currency pair is 5%, your initial outlay would clock up merely $18,373.50 (GBP 15,000).

Risk management in forex: building a trading plan

What, when, why, and how - your trading plan has to answer these questions. Your risk management strategy needs to reflect your trading plan. There is not much you stand to gain by following others’ trades.

Risk management in forex: risk-reward ratio

In the long run, you would like to be making money. Your profits have to outweigh your losses. The risk-reward ratio would quantify the worth of a trade.

To get the ratio, you compare the amount of money you are risking on a forex trade to the possible gain.

When the maximum potential loss on a trade is $200, and the maximum possible gain is $600, the risk-reward ratio is 1:3.

Risk management in forex: stops and limits

Since the forex market is particularly volatile, it is vital to decide on your trade’s entry and exit points prior to your opening a position. This can be accomplished thru several stops and limits:

Stop orders

These Will close your position automatically if the market movement is unfavourable to you. However, there are no guarantees against slippage.

Limit orders

These will follow your profit target, closing your position when the price hits your opted for level.

Risk management in forex: the eventful & the newsworthy

Forecasting forex pair price movements can be challenging. Ascertaining that you are not caught unprepared, you have to keep an eye on central bank decisions and announcements, market sentiment, and political news.

Conclusion

The key to risk management is risk measurement. Over leverage and illiquidity are two cardinal sins you must avoid, like the plague. No pain, no gain. Take on risk within a reasonable amount. The whole project should match your trading plan. Your risk-taking will be rewarded. Risk management in forex is a necessary evil, like friction in the act of motion.