Risk Management is key to trading a profitable account. It really doesn’t matter how amazing the strategy or system is, without proper risk management its just a form of gambling. Risk management is what differentiates gambling from trading and without it, your account will almost certainly drain away.
Every trader makes losing trades. It is impossible to place winning trades every single time. The key is how controlled those losing trades are. Good traders understand risk and will manage risk in order to allow themselves to continue trading.
The concept of risk management is very simple; however, it is much harder to implement.
What is risk management?
Risk management is applying controls to trades and your account in order to protect your capital. There are different ways of applying risk management, for example, stop losses, only trading certain hours, keeping an eye on lot size and trade exposure.
Why is it important?
Forex trading is trading on leverage. This means that you borrow capital to increase your trading exposure. So, you can gain exposure to much larger trade sizes with a comparably small amount of capital. Whilst this is great news as far as potential profits are concerned, it is not so good for potential losses. If the trade goes in your favour, using a small amount of trading capital you could earn much larger profits. However, if the trade goes against you the losses will also be magnified.
Managing risk is protecting the capital in your account. It is not allowing losing trades to drain your account.
Controlling losses is one way to control the risk on your account. This is often done using a stop loss. A hard stop loss is a stop loss that you enter on your account to close the trade if a certain price is breached. Mental stops are also used by some traders, however, the mental stop, where you have in your head the price that you want to close out and tends to be less successful. This is because the trader is still open to many emotions, which could prevent the stop from being executed.
Deciding where to place a stop is a science in itself. This article won’t go into stop loss placement, but keep in mind that it is best to use the market structure when placing stops rather than just arbitrary numbers.
Using Correct Lot Sizes
There is no magic formula for figuring out lot size. The key point here is that if a trade size is too large for the account and then it moves slightly against you then you could lose the funds in your account very quickly or have the trade closed out. Smaller is definitely better here, understanding the risk of trading a larger lot on a small balance is essential. With smaller trade sizes you are able to remain flexible and the psychological impact of the trade is also likely to be smaller.