Forex risk management is an important issue, this is due to changes in dynamic market trends. In this forex risk management guide, you will get to know several methods in which traders use these methods to make a profit from forex trading.
Risk management is very closely related to money management, which is an important part of learning forex trading.
A good trading system, as well as a powerful strategy, doesn’t work well without using risk management and money management in it.
Risk management explained
In the context of the forex business, risk management is any process that is carried out solely to minimize or even prevent risks in forex trading.
Inside it, there are activities of identification, planning, strategy, action, monitoring, and evaluation of negative things that are likely to happen to a transaction.
On other hand, this type of management is one method of preventing trading from running into trouble. Such as collapse, big loss, margin call, or the worst is stop out.
This risk management systematic strategy needs to be executed, especially for novice traders.
Assessing risk can be done by observing the average price change in a currency pair. For example the EURUSD pair in its daily movement with an average price movement of 100 pips.
By taking this information traders can adjust the maximum risk in case of the worst mistake. You may be able to place a stop loss within 100 pips, but you must also adjust it to the position size of the transaction.
In risk management, the process of identifying risks is also very good to do, because it is related to market changes that are sometimes so fast.
Several issues that can trigger trend changes include changes in interest rates. High impact news, and other possible causes such as natural disasters that can affect changes in market trends.
With an earlier identity of the possible risk of volatility, traders can reduce trading pressure, with anticipation that can be done for protection.
Control risk is a process of risk management that can be done from the early of trading.
Traders may easily control risk by calculating the maximum risk in one trade. But actually, the most important thing is to guard it with discipline. This may be quite difficult for novice traders because emotional bias can spoil any plan that has been drawn up in detail.
Reviews control risk
Reviews control risk is an evaluation process by traders concerning the risk management method applied. This is by calculating and then estimating the percentage of success in reducing risk.
If a risk management method produces the worst results, it is not a good method to apply in the long run.
Forex risk management method
In forex trading, the most popular risk management method used by traders is to use stop losses.
But actually, several other methods are also used by traders, especially those who are experienced.
Because this method has a high risk with a high probability of gain, and there is a moderate one with a moderate gain. The point is forex trading the higher the risk, the higher the chances of gain.
Below is the following type of risk management method:
- Use stop loss.
- Switching trading.
- Averaging trading.
- Martingale trading.
- Hedging trading.
Let us talk one by one type to get a depth insight.
Risk management use stop loss
Stop Loss is a certain price limit value that is placed to limit losses. When the price movement touches this value, the system will automatically close the order.
For some traders, this may be an uncomfortable choice, because once the value is touched, the chance for profit is lost and ends in a loss.
But stop-loss limits are placed by traders especially those who feel imperfect in identifying market trends.
Because once the order is opened, the profit and loss positions are still floating and have not been realized. So there is a possibility if the order position goes against the trend.
Equity will be lower, and so will margin level. If there is no stop loss, it could be due to a strong trend against the order. And causing the margin level to reach the threshold level, forcing the broker to close the automatic position which is called a margin call.
Types of stop-loss based on the way
Although a stop loss is a stop loss at a certain price level, in practice when using the Metatrader 4 platform it can be done in three ways.
- Manual stop loss or in a general term called cut loss.
- Automatic stop loss.
- Trailing stop loss.
Manual stop loss
Manual Stop Loss is a stop loss by a trader by closing an order position manually via the trading platform.
This is done by traders when the price turns out to have missed a move in the opposite direction to expectations.
For example, you open buy EURJPY at the price 126,286, but it turns out that the price drops to the level 126,256. Because you are worried that the price will continue to fall, then you close the order manually at the price of 126,256.
The easiest way to cut loss manually is to click the “X” in the ticket order column to the right of the profit column on the Metatrader 4 platform.
The drawback to using manual stop loss is possible to face requote, or slippage because sometimes the price moves rapidly. So it may occur you get the price in different level and possibly the loss will wider.
Automatic stop loss
Automatic stop loss refers to the stop loss which will be closed automatically once the requested price has been reached.
The most common way of activating automatic stop loss is to set the stop-loss price level before traders execute their orders.
When you click new order or with the F9 button, the order execution window will appear. In one of the boxes, there is a stop-loss option, then a price level is filled which you think is the place risk limit in your order.
Pros and cons automatic stop loss
The distance between the asking price and the stop loss level is at least 10 pips, so for example you make a new position on EURJPY at 126,220, if you open to buying, the stop loss distance is at least 126,210, it can’t be at 126,215 for example.
The advantage of setting an automatic stop loss is that you can leave the chart feeling more relaxed because the broker will automatically close your position if the stop loss level is reached.
But the drawback of automatic stop loss is if the price hits stop loss then bounces back and moves to profit target.
Trailing stop loss
Trailing stop loss can be said to be a semi-automatic stop loss, where this feature will change the stop loss level automatically without the trader modifying the order.
This trailing stop will actively shift the stop loss when a trading position is in line with the market trend.
Depends on the trailing stop distance setting. For example, if you set a trailing stop of 10 pips, the stop loss will automatically be shifted after the price moves over 10 pips from the asking price.
How to set a trailing stop
To activate a trailing stop, first, you open a new order, no need to set a stop loss. After the order is open, then highlight the order ticket and right-click on your computer mouse.
It will bring up a new window with several options, just highlight the trailing stop and the numeric options will appear to choose your trailing stop settings.
You can choose 10 pips or 20 pips or a custom option for options according to your own settings.
Pros and cons trailing stop loss
A trailing stop is a feature that is only active when the MetaTrader platform is connected to the broker’s server.
So if you set a trailing stop then close the platform and leave. The stop loss recorded by the broker is the last stop loss when the trailing stop has been activated and sets the automatic stop loss.
This is a drawback of trailing stop loss. Meanwhile, the pros to using trailing stop is, it will automatically protect profit when the price move on the line of position.
Risk management switching
The switching strategy is switching order positions when the first-order position is considered wrong because it is against the trend.
Traders can perform switching by opening a new order that is opposite to the first order, then closing the first position which is considered a wrong position in the direction of the trend.
Why use switching?
The most common reason traders do switching is the first position against the trend and worrying about it getting bigger. Switching is sometimes done by traders in panic conditions because they see the price against the order suddenly.
The hope of doing switching is that the trader will profit on the second position to cover the losses on the first order.
What the point to pay attention to?
Switching is a difficult strategy, because if it turns out that the second-order position gets wrong again, then losses will occur faster.
What traders need to pay attention to with switching is to see if the price is really at the lowest or highest point in a timeframe. If switching is just for panic, it could be that the change in trend is just a whipsaw
Pros and cons switching trading strategy
Switching has the advantage of allowing it to cover the previous losses because the first order against the trend. But the drawback of switching is the frequent whipsaw movement, or false reversal, that appears.
For example, if a trader opens a Buy JPY/USD position at the price of 116.00 and when the current price is 115.50.
Then trader will immediately close the first transaction and open a new transaction with a sell transaction at the price of 115.52 and expect the price to continue moving. down, so that we can make a profit.
Risk management averaging
Averaging is opening a new position with the same option as the first position, say the trader opens a buy order, then a second-order also with a buy option.
This is usually done when the trader faces a floating loss and opens the same position, the hope is that the price trend will move again towards the initial track.
For example, Averaging Down: Open a position (OP) with a buy EUR / USD 0.01 lot at the price of 1.2545 and set a Take Profit (TP) target of 20 points at 1.2565.
However, the price went down, so then bought another 0.01 lot at the price of 1.2525 and placed a TP at the price of 1.2555.
The price actually went down, so it returned to buy EUR / USD 0.01 lot again at 1.2505, with a TP of 1.2535. Finally, the price rose and touched the first TP target, which is at 1.2535. I close the two positions manually because if you add them together, the result is a profit.
Averaging is opening a trading position with the same position size as the previous order. Based on this averaging can be divided into two types:
- Averaging down.
- Averaging up.
What is mean?
Averaging down has a common understanding. This is opening a new position with the same position size when the price has dropped from the previous position.
A simple example, you buy 0.1 lot EURJPY at 126,220, after a few hours the price drops to 126,120, because you think the price will go up again, you decide to open buy 0.1 lot at 126,120 with the hope that the price will go up again.
Now all your positions are 0.2 lots but get a different price. So averaging down is adding to your buy position with the same lot when you experience floating loss. This also applies to short positions.
Averaging up is adding a new position with the same position size when the first position got floating profit. For example, you open a buy position of 0.1 lot EURJPY at 126,220, a few hours later the price goes up to 126,320.
Because you think the price will continue to rise higher then you decide to add a new position of 0.1 lot at the price of 125,320.
Now you have a 0.2 lot position, with the expectation that the price will go up even higher. So averaging up is adding new orders after the previous orders face floating profit. Order types can be open buy or sell.
Averaging pros and cons
Averaging will work optimally to provide higher gain if all transactions end in profit. However, when the price trend reverses and goes against all positions, the possibility of losing money will come faster because the size of the open positions is higher.
Risk management martingale
Martingale at first glance is similar to averaging in how it works. What distinguishes is the number of position sizes used, the martingale opens the next order with a position size that is higher than the previous order.
Based on how to increase its position there are two types of a martingale:
- Anti martingale.
What is mean?
The general definition of martingale is adding new orders using a higher position size than the previous position when the previous position faced floating loss.
A simple example you open buy 0.1 lot EURJPY at 126,230. After a few hours, the price fell to 126,210. At that level, you think the price will go up so you open a new order by buying 0.2 lots at the price of 126,210.
Now all your positions are 0.3 lots with two orders at different ask prices.
Anti martingale is the opposite of martingale in terms of looking at floating positions of trading results.
The mean of anti martingale is adding new orders with a position size that is higher than the previous position when the previous position faces floating profit.
For example, you open buy 0.1 lot EURJPY at 125,220, a few hours later the price rises to 125,240. Because you think the price will rise even higher, you decide to add a new position by buying 0.2 lot EURJPY at the price of 124,240.
Now you have a total position of 0.3 lots from all your orders.
Martingale pros and cons
Martingale can cover previous losses with only one position with a higher lot size, and the anti martingale can provide a higher gain than previous profits. This can happen when the second-order ends with a profit.
But if after the second position is open and the price is still against the position, the loss at Martingale will decrease the margin level faster because it uses a higher position size.
In the anti-martingale position, the loss may not be too large because the first position has floating profits, thus increasing equity.
However, martingale can get a margin call faster, therefore martingale risk management requires a large amount of capital.
Risk management Hedging
Hedging is a risk management strategy used in limiting or offsetting losses from price fluctuations.
If in manual trading, stop loss and automatic stop loss, the losing trader’s position will be closed automatically when the price reaches the Stop Loss level or a Margin Call occurs, or if the trader makes his own Cut Loss.
In that scenario, the trader will definitely lose. However, if a trader uses the hedging strategy. The trader has the opportunity to minimize the amount of loss, or even break-even point, or even make a profit.
How to hedge
Hedging strategies can be implemented in many ways in any financial market. Whether the stock market, commodity futures market, or the forex market.
In the hedging scale in various financial markets, this is done by market players in various ways to hedge, as listed below:
- An export-import company buys a Futures or Forward contract on one currency versus another. As a means of protecting against changes in exchange rates.
- Manufacturing companies buy Forward or Futures contracts. For example, Gold, Iron, or other futures contracts to protect themselves from changes in commodity prices.
- Traders buy and sell stocks and stock index (CFD) at the same time.
- A forex trader opens an opposite order when the trend is not in line with the first position. For example, buys USD / JPY and turns out to face the fact that the price is decreasing.
- Another way of hedging forex traders is to open buy or sell several related currency pairs at the same time. For example GBP / USD, EUR / GBP, and EUR / USD.
Hedging pros and cons
Hedging in forex is done by opening a buy and sell position in the same pair. Or another way with buying and selling in a positively correlated pair. It is also possible for negatively correlated pairs. Such as AUDUSD and USDCAD, but with a buy position on both of them or sells on both.
The advantage of hedging is that it hedges value by not closing previous trading positions.
In hedging trading one pair. A new floating loss position will be opened if the trader closes one of the pairs.
In pair correlation hedging trading, floating profit and loss anomalies will depend on price changes in each pair. This allows you to make a profit when a pair with higher price changes gets to the exact position of your order.
What the best risk management?
From several ways, the risk management methods described above may ask, which one is the best?
One of the main points in forex trading is the accuracy of the analysis. This is what is often the main dilemma of most traders. Because maybe you have experienced when the open buy price drops. And on the other hand, open sell then price rise up.
But the consequence of the highest risk is with martingale trading. So if you are a low-risk trader you should avoid the Martingale strategy.
The second is averaging down, the risk will be higher if all positions go against the market trend. The third is anti-martingale, and the fourth is averaging up.
In the fifth position, the risk is measured by automatic stop loss. Then manual stop loss or cut loss is followed.
Meanwhile, hedging can provide a risk limit within a floating tolerance. This means it will depend on the extreme conditions of the pair with your trading position and your decisions.
Risk management guide only the way to learn about basic risk with several methods in trading.
The most important is a skill to analyze the trend market itself. And risk management as the one way to protect from big loss or bankruptcy.
All decisions will up to you as the account holder and no other has responsibilities for all decision trading.