Today, I want to add to that by talking about risk management. This is perhaps the area where 95% of Forex traders make mistakes and lose money. Managing risk is about reducing your losses AND about protecting trade capital by employing specific strategies to accomplish each of these simultaneously.

What do I mean by that and why is it important?

First, most Forex traders make simple trading mistakes: they take too large of a position and expose themselves to serious and steep losses should the markets move against them. Second, they fail to protect their ENTIRE account by allowing ONE trade to put their full account balance at risk.

Here’s a quick and perhaps extreme example:

Suppose a forex trader has a $10,000 account balance. The forex trader takes a 5 standard lot forex trade on the EUR/USD pair. The forex trader now has at least $5,000 ‘margin’ at risk (or 50% or more of the forex trader’s account balance).

For every 1 point that this forex trade moves against the forex trader, the trader loses 1/2% of the total account balance. At first glance, that may not seem like a steep loss. However, should the Forex trade move a total of 50 pips against the Forex trader, and the trader subsequently exits the position, the forex trader’s total loss would be an INCREDIBLE $2,500! (25% of the trader’s account balance). This is poor risk management and it frequently leads to complete wipeouts of Forex trading accounts.

How did we calculate that loss? 1 pip for the EUR/USD pair is equal to $10 (on a standard lot trade). A 50 pip loss equals a monetary loss of $500; and remember our example forex trader had traded 5 standard lots — for a whopping loss of $2,500!

Instead, any trading method should teach you very specific guidelines for incorporating money management and risk management into every forex trade you take.

Money Management should involve the distribution of a forex account among the various trades a forex trader takes. For example, forex traders should never trade their entire account on a single trade, and should rarely have more than a few open positions. By utilizing multiple positions, the forex trader distributes the risk among each of the forex trades they have taken.

Risk management should involve the maximum risk in any SINGLE Forex trade, and should limit the impact of a losing Forex trade on the trader’s account balance.

Here are two quick examples:

Money Management: A theoretical forex trader takes 4 separate one lot trades on four separate pairs. Assuming here that each of the pairs have a pip value of $10 on a standard lot, then the total amount of the account being margined across all four trades is about 40% (it may be higher depending upon the actual pairs traded. With proper stop loss management, however, in conjunction with risk management, it is UNLIKELY that the forex trader would incur a complete 40% loss.

Carrying forward to risk management: In each of the theoretical forex trades above, the forex trader risks no more than 2% of the trader’s total account balance on each forex trade. That means a maximum loss of $200 per forex pair traded if ALL FOUR trades are stopped out. Total loss in this case would be $800 — a much more recoverable scenario than the $2500 in the first forex trade example.

Furthermore, Risk Management has the capacity to make loss recovery easier. For example, in the first case, where the Forex trader lost $2500, the trader would need a nearly 250% gain on their next trade to recover the lost value on the first trade.

In the second example, however, the forex trader would need only an 8% gain.

A second part of Risk Management not typically discussed in poor trading methods is protecting gains. Though this begins as a discussion on Exit Strategy rules, it is also an element of risk management. Once a forex trade turns profitable, it is imperative that the forex trader manage the gains with smart stop loss management. The worst thing a forex trader can do is allow a profitable position to reverse and become a losing position. Thus, managing risk extends to the protection of gains on a forex trade, just as it does protecting against deep losses on a forex trade.

Therefore, in considering any trading method for use in your Forex trading, you must ensure that risk management is not only discussed, but clearly explained in conjunction with the use of the trading method. If risk management is not present, unclear, or not specific to the trading method, you should avoid using that trading method.

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