Introduction
In today's world, trading on the currency market has become commonplace. Emotions that might arise during trading include excitement, fear, disappointment, and euphoria—sometimes all within the first few minutes.
There will be highs and lows in the realm of retail forex trading, which can be both a lucrative and difficult endeavour for seasoned traders and beginner or novice traders.
Being able to control the risk on your trading account is one of the biggest obstacles. The ability to protect your capital in the event of negative market movements is just as important as trading profits. One easy method to achieve this is to incorporate stop-loss (SL) and take-profit (TP) orders into your overall trading plan.
In this post, we'll teach you how to manage risk in Forex trading by effectively setting stop-loss and take-profit orders. Protect your investments.
What is risk management in Forex Trading?
One of a forex trading plan's most crucial elements is risk management, which can distinguish trading from gambling. Trading without considering the associated risks is equivalent to gambling. However, trading is all about taking calculated chances to reduce losses and maximise gains.
In essence, risk management is a set of guidelines intended to reduce your losses and keep your trades' risk-to-reward ratio within a fair range.
You should first identify the type of trader you are and what your personal tolerance for risk is. To increase their potential reward, some traders are eager to take on more risk. Conversely, other traders would rather minimise their risk since they are more risk averse.
Determining your level of risk appetite will assist you in figuring out how much to risk on each deal. Conservative traders may want to risk 0.5–1.0% of their account balance each deal, while aggressive traders may risk 2-3%.
The risks of forex trading
Leverage is one of the main risks associated with forex trading. Leverage can help you make more money, but it can also make your losses bigger.
Leverage gives you influence over a position that is significantly larger than your real account balance, much like a credit card can enable you to spend considerably more than you have in your bank account. The chance that you could lose all your money increases with leverage.
Liquidity is an additional risk. This is one example of the market opening on Sunday evening (New York Time). There will be very little liquidity, and a large weekend gap is a real possibility. It is possible for traders to be taken off guard, particularly if something unexpected happened over the weekend when the market was closed.
Even on weekdays, when the markets are open, liquidity might vanish. This exposes traders to slippage when opening and closing positions.
Technology risk could have an impact on traders. It may be a small problem, like your home internet connection malfunctioning. Two decades ago, a malfunctioning home internet connection would have been disastrous for traders, but today, most of them have installed their trading platform on a mobile device.
Conversely, a significant outage at your broker can keep you from using the platform and, consequently, from managing your positions. Regardless of the technology you are using, you would not be able to regulate your positions, which would be a significantly more serious problem. Fortunately, these disruptions are not common and are promptly resolved.
Risk management strategies in forex trading
You should start implementing risk management into your trading strategy as soon as you have a firm understanding of your own risk tolerance. This entails deciding how much risk you are willing to take on each trade and organising your entry and exit tactics.
It may be risky to trade without stopping or realizing a profit, especially for novices. In the hopes that the losing positions will eventually turn profitable, you might be tempted to disobey your rules and leave them alone. You can effectively control your risk by putting a stop-loss order in place and having well-stated guidelines.
Trading inevitably involves emotions, but with sufficient experience, you can manage them effectively. With a well-defined trading plan, you'll be able to achieve this by developing greater discipline over time with the aid of a well-defined trading plan.
It's crucial to approach this with reasonable expectations for your abilities. A 50% monthly return is unachievable without taking unwarranted risks, and there is a considerable chance that your account could blow up. Setting more manageable goals, such as obtaining a return of, say, 3% each month, will help you control your emotions.
Additionally, you shouldn't focus only on one market. It may be time to consider alternative asset classes such as shares, cryptocurrencies, commodities, or indexes if you are utilising a trend strategy and the currency market has been stuck in an unending consolidation phase.
How much of my account should I risk on the trade?
You must first decide how much of your account balance you are willing to risk on the transaction, which in turn dictates the trade size and how much margin you want to employ. Each trader will have a different response to this, depending on their risk tolerance.
Generally speaking, you should avoid taking on more risk than 2% in any one trade. After you are comfortable with the amount of your account that you are willing to stake, you can place your stop-loss order.
Using 2% as the guideline implies that you are prepared to risk losing AU$200 on the trade; for example, if you have AU$10,000 in your trading account and are opening a long 50,000 AUDUSD position with AU$500 as a margin.
Remember that the secondary currency, in this case the US dollar, expresses a trade's profit or loss. As a result, before setting a stop-loss, you must determine the AU$200 USD value.
Every pip movement, or movement in the fourth decimal place for AUDUSD, in a trade size of 50,000 AUDUSD corresponds to a profit or loss of US$5 (50,000 x 0.0001 = US$5). If we are willing to risk AU$200, which is equivalent to US$145, we can determine that we should set our stop-loss 29 pip away from the entry price (145/5 = 29 pip).
Therefore, we would set a stop-loss at 0.7221 (0.7250 – 0.0029 = 0.7221), which is 29 pip (or 0.0029) away from the trade entry price of 0.7250.
Another good strategy is to use a trailing stop, which will "trail" positive price moves while reducing the possibility of downside losses.
For instance, if you set a trailing stop-loss with an initial level of 0.7221 and a trailing level of 29 pip, you could be stopped out at your entry point of 0.7250 with no loss if certain conditions are met (for example, the price moves higher but not high enough to trigger your take-profit order).
However, it's important to keep in mind that utilising trailing stops has benefits and drawbacks. In certain circumstances, they might provide an additional layer of protection for your capital, but they may also force you out of a trade that would have otherwise reached your take-profit level.
Setting take-profit price using a risk/reward ratio
The location of the take-profit order should be considered after you have determined where to place the stop order. The type of risk/reward ratio you choose will determine the answer.
Let's adopt a 1:2 risk/reward ratio for the sake of explanation. This suggests that you would be investing AU$200 to make an AU$400 profit. In actuality, this means that at the level of 0.7308, if our stop is positioned 29 pip below the entry price, the take-profit would be positioned 58 pip—double the stop-loss distance—above the entrance price.
To summarize the hypothetical trade's entire setup:
- In the beginning, we placed a market order to purchase 50,000 AUDUSD at 0.7250.
- If we activated our stop-loss at 0.7221, it would result in a loss of AU$200.
- We set up a take-profit of 0.7308, which, if activated, would result in an AU$400 profit.
You can utilise the price alerts feature to keep track of price swings, in addition to using stop-loss and take-profit orders to control your trading risk.
Although it is true that we have no influence over how much the forex market prices change, we do have control over the profit and loss limits we establish for each deal.
You can have a risk management strategy that not only enables you to take advantage of the lucrative trading opportunities in the forex market but also limits the losses when trades don't go your way by setting stop-loss and take-profit orders in accordance with your trading objectives. All of it is part of the highs and lows of trading currencies.
Conclusion
Every single trade you make comes with some degree of risk, but if you are able to quantify that risk, you will be able to manage it. Remember, using excessive leverage in relation to your trading capital can amp up risk.
Additionally, a lack of market liquidity can increase risk. Take this into consideration. Only a disciplined strategy and strong trading habits can enable you to take some risk and earn good results.
