Beginners guide on how to use risk management in forex trading

Beginners guide on how to use risk management in forex trading

Before learning about forex trading, you should know about the concept of forex. The word forex is an amalgamation of two words: foreign currency and exchange. The process (forex or foreign exchange) is the method of changing one country’s currency into another for reasons such as trading, tourism or commerce.

Forex trading is when you trade one currency against the other in pairs, also known as currency pairs. These pairs look like USD/INR or say USD/CAD, which is also called the dollar-loonie pair. For instance, USD/CAD involves currencies of two countries, the USA and Canada. Forex trading involving this duo means US dollar is getting exchanged against the Canadian dollar. Likewise, USD/INR means currencies of the USA and India are getting traded.

So, like any trade, this involves profit and loss too. Forex trading, however, is tricky because of its volatility. Like, currency rates change randomly, leaving the trader perplexed. Similarly, interest rates undergo sudden alterations. So, if you are not aware of the risks or are not interested, you are basically gambling.

Managing the risks in forex trading ensures that the losses sting you the least.

What is risk management?

You should approach forex trading as a long-term investment plan- and so, you should know how to control the losses. This way, you are guaranteed of a chance, at least, of making profits. This principle is the core of risk management. It’s a frequently overlooked prerequisite to a successful and active trading. But risk management not only helps reduce losses, it also protects a trader’s account from getting empty.

What is Forex risk management?

As mentioned, forex is an unpredictable market, so risk management assumes maximum importance here. These are the following risks forex traders face-

a) Currency price fluctuation

b) Abrupt decrease/increase of interest rates

c) Liquidity (where you cannot trade swiftly to avoid making a loss)

How to reduce the risks in forex trading:

To outdo the risks, you must follow the steps given below:

Now let’s elaborate on each of these factors:

  • Understanding how the forex market works

It’s a global market, to start with. So it involves currencies from all over the world. Naturally, its trading is dependent on demand and supply. There are three kinds of forex market:

Spot market (This is where physical exchange takes place, i.e., on the spot)

Forward market (It’s a contractual exchange process, where currency amount, price, date, all are set)

Futures market (This is same as forwards, except that this is legally binding)

  • Make an efficient trading plan

Approaching anything in a planned or methodical manner yields more results that simply diving in. And in money matters, this is all the more important. So, if you are new to forex trading, make a solid plan. A plan that is your own, because there is not point copying someone else’s process.

Maintain a trade diary or a journal. In it, you should always be able to answer the basics of trading: The what, when, why, and how much to put in.

  • Frame a ratio of risk vs reward

This is important, as this serves as a motivation or incentive for you to continue with forex trading. If you are a beginner, the returns to the capital you have invested should be worth going ahead with. To find this ratio, see how much money you are risking on a forex trade and compare it with your potential gain. In other words, you should be making profit in the long run, despite losing out on individual trades.

  • Having knowledge about the entry and exit points of your trade

There are different types of entry and exit points, like normal stops, limit orders, trailing stops and guaranteed stops.

While normal stops enable you to close your position the moment the market is tiding against you, guaranteed stops will bail out at the specified price. The latter eliminates slippage risk, while the former gives no such protection.

Meanwhile, limit orders will close only when the level touches your profit target. Trailing stops will trail the positive price movements and close when market goes against you.

  •  Keep a demo account to start with

As the title suggests, it’s a simulation of how the trade works in actual life. It is a recreation that is as close to the ‘real’ trading as possible. Through this, your confidence builds up. And, you are not even losing any money here.

Important points to remember before forex trading

  • Keep your emotions under check. Impartial attitude is the key here.
  • Make a point to watch news and read about the announcements made by the central bank and other agencies.
  • Always study the market. Further, to trade, research about political influence and market sentiments.

Happy trading!

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