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How to manage risk in forex trading?

Let's look at an example to see how you can effectively manage risk while trading the forex markets.

Example trade: AUDUSD

Let’s assume you have AU$10,000 in your trading account. You’ve decided that you think the AUDUSD rate is going to go higher, so you want to buy this currency pair.

You’ve also decided to use 5% of your trading account value as a margin requirement to cover this trade, which equals an amount of AU$500 (10000 x 0.05 = 500).

You then decide to trade AUDUSD at a margin rate of 1%, or in other words, using a leverage ratio of 100:1. This means that with AU$500 worth of margin you can open a position size of 50,000 AUDUSD (500 is 1% of the overall position size, so multiplying this by 100 will give us the total position size of 50000).

To enter the trade using a 1% margin rate, you place a Market Order to buy 50,000 AUDUSD @ 0.7250, which is the current market price.

How much of my account value do I want to risk on the trade?

After working out how much margin you want to use (which then determines the trade size), you need to work out how much of the account balance you’re willing to risk on the trade. The answer to this will vary from trader to trader, and it will depend on your risk tolerance.

A general rule of thumb is to not risk more than 2% on any one trade. Once you’re comfortable knowing how much of your account you’re willing to risk, you can then work out where to place your Stop Loss order.

Back to the trading example – if there’s AU$10,000 in the trading account, and you’re using AU$500 as margin to open a long 50,000 AUDUSD position, using 2% as the guideline means you’re willing to risk losing AU$200 on the trade.

At this point it’s worth remembering that profit and loss on a trade is generated in terms of the secondary currency, which in this case is the US Dollar (because it’s listed second in the AUDUSD pair). So, before placing a Stop Loss, you need to work out what the equivalent of AU$200 is in USD. Based on an exchange rate in this example of 0.7250, the answer is US$145 (200 x 0.7250 = 145).

In a trade size of 50,000 AUDUSD, every 1 pip movement (a movement in the 4th decimal place for AUDUSD) equates to a profit/loss of US$5 (50,000 x 0.0001 = US$5). If you’re willing to risk AU$200, which is US$145, it means our Stop Loss should be placed 29 pips away from the entry price (145/5 = 29 pips).

Therefore, based on the trade entry price of 0.7250, a Stop Loss would then be placed 29 pips away (or 0.0029) at 0.7221 (0.7250 – 0.0029 = 0.7221).

Using a Trailing Stop can also be a good choice, as the Stop will ‘trail’ favourable price movements while limiting the scope for downside losses.

For example, a Trailing Stop loss could be set with an initial level at 0.7221, but with a trailing level of 29 pips, meaning that under certain conditions (such as the price moving higher but not high enough to trigger your Take Profit order) you could then be stopped out at your entry point of 0.7250 with a zero loss. But it’s worth remembering that there are advantages and disadvantages to using Trailing Stops, so while there are situations where they will add another level of protection to your capital, they can potentially also cut you out of a trade that otherwise would have triggered your Take Profit level.

Setting Take Profit price using a Risk/Reward Ratio

Once you know where to place the Stop Order (in accordance with how much you’re willing to risk on the trade), the next thing to consider is where to place the Take Profit order. The answer to this will depend upon what sort of Risk/Reward ratio you decide to have.

For the purposes of illustration, let’s assume we use a 1:2 Risk/Reward ratio, which would mean that you would be risking AU$200 in trying to achieve an AU$400 profit. In practical terms, this would mean if our stop is placed 29 pips below the entry price, the Take Profit would be placed 58 pips (i.e. double the Stop Loss distance) above the entry price at the level of 0.7308.

To recap the entire hypothetical trade set-up:

• We initially placed a Market order to buy 50,000 AUDUSD @ 0.7250.
• We initiated a Stop Loss at 0.7221, which would result in an AU$200 loss if triggered.
• We put in place a Take Profit at 0.7308, which would result in an AU$400 profit if triggered.

In addition to using Stop Loss and Take Profit orders to manage your risk when trading, you can also make use of the Price Alerts function to stay informed of price movements.

While it’s true that we can’t control price movements in the forex market, we can control the profit and loss parameters we set up around the trade.

By setting Stop Loss and Take Profit orders in accordance with your trading objectives, you can have a risk management approach that not only allows you to take advantage of the profitable trading opportunities in the FX market, but one that also enables you to limit the losses when trades don’t go your way. It’s all part of the highs and lows of forex trading.