Top risk management strategies in forex trading
Volatility within the FX market presents a range of opportunities for profit, but this also comes with added risk. Learn about the risks associated with forex trading, and find out how to manage them.
What is forex risk management?
Forex risk management enables you to implement a set of rules and measures to ensure any negative impact of a forex trade is manageable. An effective strategy requires proper planning from the outset, since it’s better to have a risk management plan in place before you actually start trading.
What are the risks of forex trading?
- Currency risk is the risk associated with the fluctuation of currency prices, making it more or less expensive to buy foreign assets
- Interest rate risk is the risk related to the sudden increase or decrease of interest rates, which affects volatility. Interest rate changes affect FX prices because the level of spending and investment across an economy will increase or decrease, depending on the direction of the rate change
- Liquidity risk is the risk that you can’t buy or sell an asset quickly enough to prevent a loss. Even though forex is a highly liquid market, there can be periods of illiquidity – depending on the currency and government policies around foreign exchange
- Leverage risk is the risk of magnified losses when trading on margin. Because the initial outlay is smaller than the value of the FX trade, it’s easy to forget the amount of capital you are putting at risk
Understand the forex market
The forex market is made up of currencies from all over the world, such as GBP, USD, JPY, AUD, CHF and ZAR. Forex – also known as foreign exchange or FX – is primarily driven by the forces of supply and demand.
Forex trading works like any other exchange where you are buying one asset using a currency – and the market price tells you how much of one currency you need to spend in order to buy another.
The first currency that appears in a forex pair quotation is called the base currency, and the second is called the quote currency. The price displayed on a chart will always be the quote currency – it represents the amount of the quote currency you will need to spend in order to purchase one unit of the base currency. For example, if the GBP/USD currency exchange rate is 1.25000, it means you’d have to spend $1.25 to buy £1.
There are three different types of forex market:
- Spot market: the physical exchange of a currency pair takes place at the exact point the trade is settled – ie ‘on the spot’
- Forward market: a contract is agreed to buy or sell a set amount of a currency at a specified price, at a set date in the future or within a range of future dates
- Futures market: a contract is agreed to buy or sell a set amount of a currency at a set price and date in the future. Unlike forwards, a futures contract is legally binding
Get a grasp on leverage
When you speculate on forex price movements with CFDs, you will be trading on leverage. This enables you to get full market exposure from a small initial deposit – known as margin.
While trading on leverage has its benefits, there are also potential downsides – such as the possibility of magnified losses.
Let’s say you decide to trade GBP/USD using CFDs, and the pair is trading at $1.22485, with a buy price of $1.22490 and a sell price of $1.22480. You think that the pound is set to gain value against the US dollar, so you decide to buy a mini GBP/USD contract at $1.22490.
In this case, buying a single mini GBP/USD CFD is the equivalent of trading £10,000 for $12,249. You decide to buy three CFDs, giving you a total position size of $36,747 (£30,000). However, because you’re trading the forex pair using leverage, your margin will be 3.33%, which is $1223.67 (£990).
Learn more about leverage
Build a good trading plan
A trading plan can help make your FX trading easier by acting as your personal decision-making tool. It can also help you maintain discipline in the volatile forex market. The purpose of this plan is to answer important questions, such as what, when, why, and how much to trade.
It is extremely important for your forex trading plan to be personal to you. It's no good copying someone else's plan, because that person will very likely have different goals, attitudes and ideas. They will also almost certainly have a different amount of time and money to dedicate to trading.
A trading diary is another tool you can use to keep record of everything that happens when you trade – from your entry and exit points, to your emotional state at the time.
Set a risk-reward ratio
In every trade, the risk you take with your capital should be worthwhile. Ideally, you want your profit to outweigh your losses – making money in the long run, even if you lose on individual trades. As part of your forex trading plan, you should set your risk-reward ratio to quantify the worth of a trade.
To find the ratio, compare the amount of money you're risking on an FX trade to the potential gain. For example, if the maximum potential loss (risk) on a trade is £200 and the maximum potential gain is £600, the risk-reward ratio is 1:3. So, if you placed ten trades using this ratio and were successful on just three of them, you would have made £400, despite only being right 30% of the time.
Use stops and limits
Because the forex market is particularly volatile, it is very important to decide on the entry and exit points of your trade before you open a position. You can do this using various stops and limits:
- Normal stops will close your position automatically if the market moves against you. However, there is no guarantee against slippage
- Guaranteed stops will always be closed out at exactly the price you specified, eliminating the risk of slippage1
- Trailing stops will follow positive price movements and close your position if the market moves against you
- Limit orders will follow your profit target and close your position when the price hits your chosen level
Manage your emotions
Volatility in the FX market can also wreak havoc on your emotions – and if there's one key component that affects the success of every trade you make, it’s you. Emotions such as fear, greed, temptation, doubt and anxiety could either entice you to trade or cloud your judgment. Either way, if your feelings get in the way of your decision-making, it could harm the outcome of your trades.
Keep an eye on news and events
Making predictions about the price movements of currency pairs can be difficult, as there are many factors that could cause the market to fluctuate. To make sure you’re not caught off guard, keep an eye on central bank decisions and announcements, political news and market sentiment.
Start with a demo account
Our demo account aims to recreate the experience of ‘real’ trading as closely as possible, enabling you to get a feel for how the forex market works. The main difference between a demo and a live account is that with a demo, you won’t lose any real money – meaning you can build your trading confidence in a risk-free environment.
When you open a demo account with us, you’ll get immediate access to a version of our online platform, along with $10,000 in virtual funds.
Forex risk management in summary
If you have a particularly effective risk management strategy, you will have greater control over your profits and losses. We offer a wide variety of tools to help you get geared for success. These include the educational resources at IG Academy, free webinars and seminars, a demo account option, forex trade ideas, and much more.
1 You will incur a premium if a guaranteed stop is triggered.
This information has been prepared by IG, a trading name of IG Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients.
CFDs are a leveraged products. CFD trading may not be suitable for everyone and can result in losses that exceed your initial deposit, so please ensure that you fully understand the risks involved.