Risk Management is one of the most important skills to learn while trading. Forex is unique among business opportunities in that it offers many different ways to manage your risk. Different brokerage firms will offer different risk management options. Managing your risk will save a lot of loss, allowing you to trade longer and learn how to trade better.
What is Risk Management?
Generally, risk management boils down to four different strategies: mitigation, avoidance, transfer, and acceptance. Risk avoidance in Forex trading would mean not trading at all, which can apply in certain cases like very volatile market movement. Risk transfer in trading will involve taking a capital guarantee or fund insurance with your broker if they offer it. Risk mitigation applies strategies like stop loss orders and hedging. Risk acceptance is simply accepting the risk of the trade.
The Risk Management strategy that you implement depends on a few things: your risk appetite, the volatility of the trading instrument, whether your position is long term or short term, and your equity. In general, you can set tighter stop losses for short-term positions, and the volatility becomes low.
Let us take an example. You are a commodity trader, and today you are trading gold. The gold price is 1484.01/1484.20. You believe the gold price will rise above 1500 before the end of the day. So, you take a buy position and set a take profit position for 1500. However, being a cautious person, you set a stop loss at 1475 as well.
|The market peaks at 1505.33/1505.53 before ending at 1493.44/1493.64||The market ends at 1470.28/1470.48|
|Action||The take profit order triggers at 1500, leaving 15.8 points in your favor.||The stop loss order triggers at 1475, leaving 9.2 points against you.|
|Profit/Loss Calculation||[ Closing Price – Opening Price ] x Contract Size x Number of Contracts +/- Financing Adjustment = Profit/Loss|
|[ 1500.00 – 1484.20 ] x 100 x 1 – 11 = $1,569 Profit||[ 1475.00 – 1484.20 ] x 100 x 1 – 11 = -$931|
|Money saved from risk management||[ 1493.44 – 1500.00 ] x 100 x 1 – 11 = $667 of potential profit/loss saved||[ 1470.28 – 1475.00 ] x 100 x 1 – 11 = $483 of loss saved|
There are clear scenarios where a take profit and stop loss can save you money as shown above. This is only one example of how stop loss and take profit work. However, there are other uses as well, such as using take-profit for what you foresee will be a small opportunity before an opposite trend occurs.
Forex Trading offers many risk management options. Learn what options are available to you from your brokerage firm. Risk management is the quintessential skill to manage your money and trade long term without having to refill your equity repeatedly.