Currency fluctuations in the Forex market provide a wide range of profitable transaction opportunities to traders, but the high profit of trade always comes with a lot of risks. Therefore each trader should be acquainted with financial management methods and techniques, as well as the risk factors before a huge investment in a position. In this article, we will introduce you to risk management in Forex; stay tuned.
What is risk in trade?
To understand loss management better, first, you have to know the risk itself. The risk of a trade is the maximum amount a trader will lose during the transaction. In other words, risk represents the difference between the trader’s expectation of trade and its actual efficiency.
The more a trader loses during the transaction, the higher the risk they have taken. In each Forex trade, the trader should invest a certain amount of money and take the best strategy to perform different positions.
It means several things when an individual suffers from a loss as big as half of their funding. First is that they probably cannot control their emotions. Second is the trader’s lack of enough knowledge of the market and its fluctuations, and the third is their unawareness of the existing risks in the currency market. Thereby, we will introduce you to the risks of the Forex world in the next part.
What are the trades’ risks?
In the Forex market, there are lots of risks in performing trading. We have brought you the most important ones, case by case along with explanations in the following part:
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- Exchange rate risk: it is a result of currency value variations. Normally exchange risk rate is due to constant changes and fluctuations in supply and demand all over the world. Thus if either the supply or demand increases or decreases rapidly, there will be a significant change in its price undoubtedly.
- Interest rate risk: it is related to the sudden increase or decrease of interest rate, which affects market fluctuations. If a 5 percent interest rate has just a 0.5 percent increase, we will witness a 10 percent increase in the interest expense. Hence interest rate augmentation will exert a huge expense and a significant effect on transactions with great volume, on the flow of cash, profitability, and business strategy. That is why the cash that had been saved for other financial opportunities will be absorbed by the interest rate change.
- Liquidity risk: even though the Forex OTC market is one of the financial markets with high liquidity; outside the USA and Europe trading hours, there are periods of illiquidity. In addition, applied restrictions on a specific foreign currency by some countries also cause a decrease in the liquidity of the market or a failure to perform a position.
- Marginal or leverage risk: deposits with margins allow high leverage, that with the smallest change of price in a position, there is a high risk of great and instant loss for the trader. As an example, if by the time of a trade, 10 percent of the contract is deposited as a margin, a 10 percent decrease in value will destroy the whole margin amount.
Now that you are acquainted with the existing risks in the Forex market, you will manage risk in Forex more knowledgeably. In the next part, we will explain control and management of trades and risk; and we will also introduce the methods of controlling a situation.
What is risk management in Forex?
In each investment, there is a potential profit for the trader, and along with it, comes a descending risk. Therefore, in addition to transaction techniques and trading in the best possible case, a trader should be aware of how to control descending risks. Risk management in Forex includes detection, analysis and disintegration, and acceptance of uncertainty in a commercial. Considering that Forex trades require huge financial risks, risk management has an important role in making a successful business possible.
Consequently, when you decide on doing a trade with a specific strategy, you should consider a suitable plan for risk management in that strategic approach. If a trader notes the right tactic and basic rules in trade and their risks, the potential incoming loss will be decreased markedly.
The more risk management of trade is logical and righteous, the less stress, better control, and more stable and safer conditions it will have. Considering all financial markets, especially Forex, have high risk due to existing fluctuations in the market, mastering risk management plays a vital role for the trader. In order for a trader to have the ability to control the existing risk in their trade, they should learn the following thoroughly:
- Complete understanding of the Forex market
- Full acquaintance with leverage
- Determination of the number of risks versus the rewards
- Usage of stop and limit
- Emotional management
- Awareness of the news and events of a day, even a moment, in the world
- Using a demo account
By learning each of these factors, you will be one step closer to controlling risk in Forex. So for you to get a better understanding of them, we will explain them in a complete and comprehensible way in the following parts.
Understand the Forex market well
The Forex market includes currencies all over the world like the dollar, euro, Yuan, etc. and these mentioned currencies are being traded in the market. Primarily currency values in the Forex market are led by supply and demand forces. Trading in the currency market is like any other financial market, in which you will buy an asset using a specific currency.
The market rate reflects that to buy a currency, how much cash should you pay? For a better understanding of the Forex market you should know there are three different currency markets including the following:
- Spot market: In spot market trading currency pairs happens exactly where you close the position. In other words, the trade happens immediately with the momentary price.
- Forward market: It is a contract with a specific price for buying or selling a specific amount of currency on an arranged date in the future. So you currently have the ability to trade in the future; as if you have time traveled.
- Future market: It is a specific contract of buying or selling a certain amount of currency set in a known time with a fixed price in the future. The difference between the future market and the forward market is in the lawful requirement that exists in the future market.
Get to know leverage thoroughly
Even though trading using leverage has its own special pros, it has some potential cons as well. When you have yet to know the market fluctuations and techniques and strategies thoroughly, improper use of leverage can lead to huge losses for you.
The amount of leverage in each broker is different considering the existing rules and laws. That being said it usually has quantities like 100:1, 200:1, and 500:1. For more information on choosing the leverage type according to market and your goal, you should read up on leverages.
Create a great trading plan
A good business plan can be a factor and a tool for your personal decision while trading. As a matter of fact, the right trading plan is a trader’s guide that will create an organization for your trades in the fluctuating Forex market. In fact, a trading plan answers important questions like what, when, how, and how much to trade. It is very important for your plan to be personalized and unique to you. If a trader copies another person’s plans, they will fail assuredly. In truth a trader’s plan is the goals, strategies, time, funds, and attitude to the market; so you will get nowhere by copying others’ plans.
Determine the number of risks versus the rewards
In each trade, the amount of risk you accept with your fund should be valuable. As a part of your Forex trading plan, you should adjust the ratio of risk to rewards, or in other words, your profit, to determine the transaction value. To find this ratio all you have to do is to compare the investment fund to the potential profit. For example, if the maximum risk potential of a trade equals 200 pounds and the maximum profit potential of it is 600 pounds, the ratio of risk to rewards is 1:3. So if in doing ten trades with the profit ratio of 1:3 you only succeed in 3 of them, even with 30 percent success rate, you will have 400 pounds of income.
Use stops and limits
Considering the Forex market is full of fluctuations, you should decide on the timing of your entry and exit in trading, before creating a position. Trading according to stop and limit also has different methods as the following:
- Normal stop: If the market is moving against your trade, by using normal stop, your position will be closed automatically. That being said there are no 100 percent guarantees against loss and slippage.
- Guaranteed stop: In this stop, your trade will be closed exactly in your intended spot, which eliminates the risk of loss and slippage.
- Trailing stop: It is in the direction of positive market movements and the moment the market moves against your position it will close the deal.
- Limit orders: It follows your profit goal and in the moment of reaching your target, it will close your position.
Manage your emotions
The existing fluctuations in the market can take control of your emotions easily. You are the most important person that affects the trade’s success. So, you should analyze and have control over emotions like rage, fear, greed, temptation, doubt, and anxiety (sentimental analysis). Each one of these emotions, if left unmanaged, could do serious damage to your fund and trades.
Monitor the world and market news and events
Predicting the movement of currency pairs is a difficult task because lots of factors affect their increase or decrease. However a part of market fluctuations is due to events all over the world, therefore you should be on alert for the decisions and notifications of the central bank, political news, and market sentiments.
Start with a demo account
The purpose of creating a demo or virtual account in Forex is to create a real environment for trade. A demo account allows the trader to recreate a real trade. By doing that, you will get to know different aspects of the market fluctuations and your attitude during trading, without losing your fund.
In summary, if a trader takes a specific strategy in managing risk in Forex, they will have more control over fund management and the amount of incoming profit and loss. To achieve a low-risk trading strategy, you should be acquainted with the Forex market, techniques, business ideas, and risk and fund management thoroughly.
Conclusion
In this “what is risk management in Forex?” article we tried to familiarize you with existing risks in the Forex market, trading dangers, risk management, and how to control it. We understood that risk in the market means the possibility of some loss in a specific trade. In the rest of our article, we learned the risks and dangers in the Forex market for traders, which included 4 aspects. We got acquainted with risk management in Forex topic and were taught the methods of controlling and containing loss. Overall if you are interested in trading in Forex, mastering risk management is one of the most important properties of trading in the currency market. So in addition to learning different analyses and strategies, you should also gain skills in risk management to have the least loss and maximum profit in your trades. Considering the countless fluctuations in the Forex market, you should enter the world of trading with full equipment, which is your knowledge.
Frequently asked questions
- Is learning fund management as important as learning analysis techniques and strategies?
Yes, one of the basics of trading in financial markets is risk management, which prevents high losses in trades.
- What risks are in the Forex market?
The major risks that exist in the currency market are the currency rate, interest rate, liquidity, and leverage.
- What does risk management mean?
It is a controlling process during which, with analysis and disintegration of the existing conditions and identifying effective methods, the incoming loss to the fund will decrease greatly.