Managing Risk
Importance of Risk Management
Crucial to the long term success of any trade is Risk Management. You should treat your trading account as you would any other business. It is important to realise that trading is not a game, it is real money and it is very easy to lose if you don’t pay attention to what you are doing. Risk Management can make the difference between a good or bad trading system.
What Is Risk Management?
Managing risk plays a central role in effective investing; this is what separates investors from gamblers. By simple definition, Risk Management understanding which risks are likely to be profitable and which are not. Traders talk would refer to this as “limiting ones risk exposure.” Of course, some risks are necessary to make a profit; however, too much risk may empty your account. It is important to find a profitable balance.
Below are three risk management techniques that can help create this balance.
Stop Loss Order
Also known as a conditional placement, they can be broken into different categories based on a traders requirements. The various types include:
- Sell Stop Loss Order
- Stop Limit Order
- Buy Stop Loss Order
- Trailing Stop Loss
- Trailing Stop Limit Order
- Bracket Order
The setting of an adequate stop loss orders in Forex is extremely important. Due to the leveraged nature of the product, the fluctuations in pricing can be quite significant on a daily basis. Current economic and monetary policy changes have spurred a new wave of volatility in the markets and will continue to cause uncertainty. Stop Loss orders are an important way to manage appropriate risk and keep within your own personal trading guidelines and rules.
Determining Trading Risk
The amount of exact risk can be determined by using a risk-reward ratio. Whilst it is important to pay attention to focus on potential gains, potential losses play an equally important role. Traders can use a risk-reward ratio to focus on both aspects of each trade. How do you determine a good risk-reward ratio? Most traders would view a 1:2 ratio as an acceptable number; a better ratio is 1:3 or 1:4. Likewise, a 1:1 or 2:1 risk-reward ratio is unacceptably risky.
Keeping The Profits
The most rewarding risk management tool is to regularly remove any profits from a winning trade. Following such a strategy allows you to keep your gains and automatically reduces your risk.
To separate between gambling and investing, you will need to implement an effective risk management strategy. It is extremely important to be disciplined with regards to Risk Management, as this will dramatically increase your chances of a long-term profitable Forex trading.
Risk: Reward Ratio
This ratio is used to compare expected returns of an investment versus the amount of risk associated with those returns. This ratio is calculated by dividing the amount of profit expected when the position closes (reward) by the amount the trader stands to lose if price moves in an unexpected direction (risk).
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