5 Ways to Control Risk When Trading ForexThere are five ways that you can help you start controlling risk when trading forex. Many of these suggestions can be implemented quite easily and quickly. But the true obstacle to implementing these ideas will be your own inner self-biases.
As a trader, your number one job is that of a Risk Manager. You must control and minimize risk at all times. This should be your primary objective. Everything else is secondary to that. This concept is difficult for some traders to really get a hold of, but it is an essential ingredient for success in the market. In this article, I will discuss 5 ways to control risk when trading forex.
Trade With a Hard Stop Loss
One of the best ways for traders to contain risk exposure in the markets is by placing a hard stop loss with every trade. Now notice that I advocate for a hard stop loss rather than a mental stop loss.
So, what’s the difference? A hard stop loss is active in the market and will be executed upon when prices reach that level. It is automatic and doesn’t require the trader to do anything more once it has been placed. A mental stop loss is typically defined as a level at which a trader has decided to exit the trade, but has not initiated a stop loss order in the market.
The main issue with Mental stops is that it is open-ended and leaves too much wiggle room for the trader. Many times, when a mental stop is reached, a trader will often justify staying in the trade even when they know it is not in their self-interest to do so. A hard stop forces you to get out of the trade, and removes some of the psychological barriers associated with taking a loss.
Every time I enter into a trade, I always place a hard stop in the market. I know that I will be the most unbiased just before I get into a trade, and so I do my analysis and select the best location for my stop loss. I set it and forget it. I know that at the end of the day, it is one of the best risk reduction measures that I can take.
Do Not Use Excessive Leverage
When it comes to trading the FX Markets there is no guarantee that you will make money. However, I can almost guarantee you that if you do not use leverage responsibly, then you will blow up your account at some point in your trading career. This is not at all to scare you, but rather to prepare you so that you learn to have a healthy respect for risk.
I see many rookie traders making the same mistake over and over again. First, they start by selecting a broker that offers them the highest leverage possible, and then they trade utilizing most of that leverage. This is a recipe for disaster.
Think about it this way. When you buy a sports car that’s able to reach speeds in excess of 200 KPH, do you expect to drive full throttle on a small community road? Of course not. It would be too dangerous and irresponsible to do that. You can cause yourself and others major bodily harm by doing so. Well, when you are trading with maximum leverage, you may not do yourself bodily harm, but you most certainly can do yourself financial harm.
Believe me when I tell you that in order to make money in the markets, you have to play the long game. Trading should not be like playing roulette, betting the farm on black or red for a spin of the wheel. That my friend is what they call gambling not trading. As traders, we need to stay in the game for the long term so that our Edge can play out through a series of trades. My rule of thumb is to cap out leverage at a maximum of 10:1, but in most cases, I am trading with only 3:1 or 4:1 leverage at most. And that’s enough to make a very healthy return in the market.
Avoid Trading During Volatile Conditions
This is a rule for controlling risk that some novice traders tend to get confused about. Many times, when I bring up this point, someone will typically ask me this: “I thought that Volatility was good because it allows us to profit from price movements”. Well, I agree with this, but the point I am making is more intended for expected short-term volatility that is associated with high impact scheduled news events or other known occurrences that can swing price action wildly.
These high-risk events that can potentially cause 100 or more pip movements in a matter of seconds. There is no real edge in trading during these times and I believe it’s best to either take a short break from trading and if you are in an open position, to reduce some risk by lowering your position size.
A few examples would include the US Non-Farm payroll report that comes out the first Friday of every month. And another example would be a Central Bank rate statement. Both of these types of news announcements tend to be highly anticipated by the market and can result in major up and down spikes after the announcement. Most technical patterns and levels can be reached quite easily from the initial price discovery following these announcements.
As a technical trader, I have learned after many years, that its best to be on the sidelines during these announcements. And by choosing to do so, I am able to control my risk considerably.
Do not Risk more than 2% Per Trade
This goes hand in hand with controlling leverage. The 2% rule has been touted by many professional traders and experts in the industry. I have done my own testing with this and find that for my own risk tolerance level, I prefer 1.5% of capital as my fixed fractional risk threshold. Every trader will have a different threshold, but generally speaking, 2% tends to be a solid max limit.
By adhering to it, you will be relatively safe from blowing up your account from a black swan event or just a normal string of losing trades. Many times, new traders neglect the highly adverse effect of a large drawdown on recovery. For example, a 20% drawdown requires a 25% return to recover to break even. A 30% drawdown requires a 42% return to recover to break even. And a 50% drawdown requires a whopping 100% return to recover to break even.
Most trading strategies and systems will see a 12R to 15R drawdown at some point. And so, with a 2% max risk per trade, a 15R drawdown would equate to approximately 30% loss level. As noted, this would require a 42% return to recover. This is difficult but doable. The problem becomes exponentially harder when you start getting into drawdowns above 30%.
So, if for no other reason than to make sure that you have a viable chance to be able to get back to breakeven after a drawdown, I would highly suggest that you keep your risk exposure to the 2% per trade level. And it wouldn’t be a bad idea to go a little lower if possible. Not only will you be able to sleep better at night, it will also help keep you in the game for the long run.
Try to Stick With Higher Time Frames
One type of risk that many traders do not discuss often enough, is the risk associated with overtrading. Often times, traders will focus on scalping or short-term day trading strategies, because they have a misguided belief that the more often they trade, the more money they can make in the markets. This is not only untrue, but it can be dangerous to your bottom line.
I advocate for a swing trading time horizon, which I define as trades that are held for about 2-10 days. Typically, you would be looking at 240 minutes, 480 minutes, and the daily charts when you are taking a swing trading approach. More often than not, the support and resistance levels and chart patterns that you will find on these higher timeframes are more valid and offer a higher probability of success.
By sticking to these timeframes, you will benefit and reduce risk in several ways. Firstly, it will help contain your impulse to overtrade on the smaller time scale, and instead, you will focus on higher time frame candles. Secondly and as importantly, sticking with higher timeframes will help you minimize your transaction costs. Transaction costs in the form of bid-ask spreads and commissions can take a heavy toll on your profitability. So, with a swing trading time horizon, you are able to offset these costs in a more efficient manner, since you would be targeting larger pip movements.
In this article, we discussed five ways that you can start controlling risk when trading forex. Many of these suggestions can be implemented quite easily and quickly. But the true obstacle to implementing these ideas will be your own inner self-biases.
Any professional forex trader that has been around the markets for a while will tell you that Risk control is paramount to long-term viability and success in the markets. It is your job as a trader to take the necessary steps to ensure your survival. Remember, it’s not the return ON your capital that is the most important thing. It’s the return OF your capital that is the most important.
Vic Patel is the author of this guest post. He has over 20 years’ experience in the markets. He is a trading educator at Forex Training Group and is a full-time trader.