Lesson 22: Introduction to Forex Risk Management

We are attacking the first lesson of what we call "the work of the trader", that is to say everything that does not really concern the analysis ... If you are wondering what the trade can ask for Analysis, you are in the right place.

What is risk management?

Risk management, also called money management, refers to a set of rules and principles that will help you maximize the effectiveness of your operations and avoid taking too much risk, or at least uncontrolled risks.

For some people, these principles will seem obvious. However, it should be borne in mind that when one really invests his money, one does not reflect more lucidly. We are gained by stress, fear, and hope , which can sometimes "pollute" our ability to make rational and effective decisions.

This is where the risk management comes in.

Indeed, by fixing in advance the strict rules , one manages to free oneself from the difficulties caused by the emotions such as fear or hope, two of your biggest enemies when it comes to trader on The Forex.

Since risk management is a somewhat catchy concept, we will teach you the most essential notions, the ones you will need directly at the beginning of your trading career

Managing your capital

First rule: do not use too much of your capital

Here, the notion of available margin is paramount. As a reminder, the margin available is the amount on which you can intervene, taking into account the leverage effect. For example, if you made a $ 1000 deposit into your account and you use a leverage of 100, your available margin is $ 100,000.

However, you should never use too much of your available margin, so beware of the leverage allowed.

For example, in the previous case, if you take a big position with regard to your capital, for example on 50,000 units, each 1 pip variation will be $ 5.

So, with a change of 100 pips in the opposite direction of your position, you lose already 500 dollars, that is half of your capital .

And once you get 200 pips lost, your capital has flown, and you undergo what is called a "margin call", which means that the broker will automatically cut your position and your account is zero ...

There are no precise rules as to what proportion of its available margin should be used, but in this case (deposit of $ 1,000, leverage of 100), it seems sensible to limit itself to positions of 10000 Units, where the value of the pip is 1 dollar on EUR / USD.

By prudently using your capital, you will be able to cope in the event of an inverse passing evolution to your position. You will be able to hold the position as long as the trend is favorable again (if you have good reason to think that your position is always judicious and you have simply made a timing error).

To conclude, we must not be too greedy . Admittedly, the bigger the position, the faster and higher the gains, but do not forget that it also works with losses!

Patiently earn gains on reasonable positions, make your capital swell, and then increase the size of your positions, this is the best path to be on to last in trading.

Risk management of positions with stops and limits

We have previously learned how to manage our capital, and now learn how to manage our positions. In this field, the notions of Stops and Limits are paramount. Let's start with the definitions:

Stop: The maximum latent loss limit is set to stop. This is the threshold from which we consider that we were wrong in our position, and that our analysis is false.

That is to say that we cut our positions as soon as the stop is reached. For example, you buy EUR / USD at 1.3060: If your stop is at 10 pips, you will set it at 1.3050, and cut your position at this course.

Limit: A limit is the opposite of a stop. It is therefore the objective of gain that is set. This is the threshold from which we consider it wiser to cash in its winnings than to hold the position. Concretely, with a limit of 10 pips, if you buy EUR / USD at 1.3060, you will sell at 1.3070.

Stops and limits can be defined "orally" or automatically , which we recommend.

You can automatically pass the orders of stops and limits on your platforms, so that the positions are automatically closed if they have reached the stop or limit.

The utility of stops and limits

The interest is obvious in the case of stops: Avoid getting caught in the game of "it's good, it will go up" , because in doing so, you will long lose positions, which will mar your margin and thus your capacity investment.

Our opinion is that if the courses go the wrong way, it is better to accept it and move on . Things are moving very fast on Forex, and it is better to accept to have been wrong than to wait for the courses to go up and to let opportunities pass.

For the limits, it will be necessary to avoid being "too greedy" while waiting too long before taking his gains on a winning position. Many traders acting thus were surprised by the speed at which the prices go down after a pic ...

An old stock-market adage says that trees never rise to heaven, and it's better to take profits too early than wait too long and face a brutal turnaround that will wipe out your winnings.

We strongly advise you to place your stops and limit orders automatically triggered immediately after taking your position, and not to touch them again . Once the position is taken, we are no longer as clear-headed, and we may be tempted not to respect the rules we have set ourselves, which is generally a bad idea.

Moreover, with automatic stops and limits, you will not have to monitor the position closely, which is more comfortable.

How to choose stops and limits?

First, you have to know that the more short-term you invest, the closer our stops and limits will be. Then, it all depends on your strategy, everything depends on the risks you want to take ...

However, it will be necessary to ensure that your limits are always wider than your stops.

Your winning positions need to earn you more than you lose your losing positions.

But this principle alone is not enough to properly position its stops and its limits. Indeed, risk management intervenes in the choice of levels on which to place its stops and its limits, but the analysis intervenes also.

You will therefore find in our Forex University a step-by-step method to know exactly where to position your stops and limits.

Conclusion

To conclude, risk management aims to help you to overcome the psychological errors, errors that can lead you to make your emotions. But for this it is also essential to know well, to know well the psychological biases to which they are often subjected: This is the subject of the following lesson.