In simple words, forex trading means buying and selling a currency against another based on speculation of the future price of a particular currency. It is basically like the currency exchange that we do while being abroad. When a trader buys and sells foreign currencies in the forex market, the exchange rate of both currencies changes accordingly as per the demand and supply. The FX market remains operational 24 hours a day and five days a week.
The major players in the foreign exchange market are the major banking institutions of the world, central banks, individual retailers, global businesses, and other financial entities. All forex trade operations are conducted in OTC (over-the-counter) mode, meaning the currencies are not exchanged physically.
The forex market offers traders multiple options for earning massive profits; however, it has its own merits and demerits. As the whole FX market works on the internet, various elements are always trying to scam and cheat the traders of their hard-earned money. The speed of transactions over the internet is also a risk factor in forex trading. The impatience of traders also make them commit impulsive mistakes, which results in unwanted losses and demotivation.
There are two ways of involving in forex trading; one is like a professional trader with a forex broker, where one calculates the negatives and positives before executing a trade. The other is like a gambler, where one runs trades based on instincts and luck. There is a fine line between trading and gambling, and that is risk management. Traders who use risk management techniques can take up forex trading as a full-time career.
Some common risks traders face in the forex exchange market are an improper use of leverage, fluctuation in interest rates, exchange platform rates, and the country’s economic condition. This article will discuss the risk management techniques for forex traders that will help them execute successful trades.
Understanding the Market Volatility
In the FX market, volatility denotes the change in a particular currency’s price over a fixed period. In simple terms, one can say it is the amount of instability in dealing with a currency in the forex market. A trader must know how to manage the volatility factor as it determines their loss and profit. The higher the volatility means, the more the chances of significant changes appearing in the price of a currency pair over a due time, which provides traders more opportunities to earn massive profits. On the other hand, low volatility means the market is in stable condition, so the prices will not fluctuate too much, which means the traders can either make large profits or may suffer heavy losses.
Volatility’s importance lies in the fact that it is necessary for creating a trading strategy, as risk traders prefer volatile currency pairs. In contrast, conservative ones may go for currency pairs with low volatility. There are various indicators that traders use to calculate the volatility of a currency pair. Here are some of the most helpful volatility indicators.
- Moving Average: It is the most commonly used indicator where the moving averages are used to calculate the average fluctuations in a market over the X period. The traders set the value of X as per their requirements.
- Bollinger Bands: This indicator has a pair of lines placed above and below the moving average indicator to calculate the relative changes in the price of a currency pair compared to previous situations.
- Average True Range (ATR): ATR is one of the best indicators to measure the volatility of a currency pair. It is used to calculate a pair’s average price over a certain period. A fall in ATR indicates lower volatility and a rise in the values of ATR suggests the volatility of a pair is increasing.
It is not every trader’s cup of tea to deal with high volatility while trading in the forex market. They tend to get impulsive, which may result in heavy losses. Here are some tips that may help traders to deal with high volatility in the FX market.
- The first tip for FX traders in the USA is that they must not panic while dealing with the forex market. Their calm in a difficult situation may cause heavy losses or significant profits.
- Before trading blindly, traders should create a plan to protect their profits and minimize losses.
- If the traders cannot deal with high volatility, they can take some professional help where the forex industry experts will manage their trading portfolio.
- The traders are advised to use their brains instead of their heart while trading currency pairs. They must not let their greed come in the way of trading strategy.
Developing a Solid Trading Plan
There are various negative myths in the market regarding the risks of the forex market. The largest financial market in the world may have some major risks. Still, it is possible to navigate these complications to profit, as numerous successful traders do. Developing a trading plan is not a very tough task, but there are specific points that one must keep in mind. Some of the critical components of a trading plan are mentioned ahead.
- It is indispensable to have a trading plan to make regular profits in the forex industry.
- The trading plan must be concrete enough to tread through difficult situations but flexible enough to deal with the changing dynamics.
- The traders must not blatantly copy others’ trading plans; instead, they must create a plan per their style and long-term goals.
- The trading plan must be well thought out, stop losses and take profit limits because exiting a trade is equally important.
- One must acknowledge all the features of the best US forex brokers, which they will use in their trading plan accordingly. The broker offers multiple financial instruments that traders can use.
- The trading plan must use technical indicators to analyze the leverage effectively.
Here are some crucial tips for new forex traders to create an effective forex trading plan.
- Before starting trading, the traders must test their skills via paper trading as it will give them a proper idea of their confidence. It will also provide insights regarding their strengths and weaknesses to address in the trading plan.
- Forex traders are advised to set their risk level per their trading style. The risk level can vary from 1% to 5% of a trader’s portfolio.
- The traders must clearly mention their trading goals in the trading plan, keeping them focused when things are in motion. One must set weekly, monthly, and annual goals and update them regularly.
- Before creating a trading plan, one must do their homework regarding the forex market. It will provide them with keen insights into the forex industry, which will help in the proper creation and execution of the plan.
- The USA forex traders must set exit rules to minimize the losses. One must know when to exit a losing trade; they can easily make an online forex brokers comparison as these platforms provide such facilities.
What are Position Sizing and Leverage
Position Sizing means buying and selling the right amount of a particular currency. It is one of the most crucial skills a trader must learn to be successful. Position sizing allows traders to make massive amounts of profits in a short period. If we talk about leverage, it is the feature that offers traders a chance to borrow extra capital to acquire a large chunk of the forex industry with a minimal deposit. Using this technique can significantly enhance their profits; however, the chances of losses also increase with the same.
In the forex market, traders can execute large trades using leverage to increase their potential. The most common leverage position used in the forex market is 100:1. Moreover, the high liquidity of some currency pairs in the FX market means that the traders can open a trade at a cyber speed. Due to this high speed, the traders are advised to set their exit points to recover if their assumption goes southwards.
The traders must consider account size and risk tolerance to calculate the position size. For example, a trader has an account size of $5000 and a risk tolerance of 1%. The SL limit of the trader is set at 200 pips per trade, and they are buying EUR/USD currency pairs. Then, the position size for this trader will be calculated as follows.
$5000 x 0.01= $50
$50/200 pips = $0.25 per pip
If they buy a mini lot, i.e., 10,000 units, then:
$0.25 per pip x [10 k units of EUR/USD]/[$1 per pip] = 2,500 units
Thus, per the calculations, the trader should open a trade with a position size of 2,500 or less if they do not want to cross their risk boundaries.
The leverage factor of forex trading must be used responsibly by the traders as it can result in massive profits and heavy losses. The traders just starting with the forex trading must limit the leverage to 5:1 or 10:1. Once they gain enough confidence and skills, they must only move to higher levels.
Stop Loss and Take Profit Orders
The whole concept of forex trading depends on two factors: stop loss and take profit, which the traders use to take control of their earnings and limit the losses. Using these orders, one can decide the funds they will earn or lose from a particular trade. Though the concept looks relatively simple, its proper application differentiates a successful trader from the masses. The stop loss (SL) feature is utilized by forex traders to automatically close a trade when the currency pair’s price reaches your speculated limit.
If we talk about the take profit (TP) order, it is used to automatically close a live trade when the currency pair’s price reaches the assumed price. The stop loss feature minimizes the losses, and the take profit order keeps the traders’ profit safe. The stop-loss order should be set logically so that it optimally minimizes your losses and gives you a moment to breathe.
One can use multiple methods to determine the stop loss and take profit orders for their trades. Some traders use these methods independently, while others combine numerous to get data; ultimately, the goal is to make informed decisions regarding closing a position. Some of those are the percentage, support, and moving average methods.
Using the stop loss and take profit orders has various benefits and risks. Some of the major ones are mentioned ahead.
Benefits of Stop Loss Order
- The foremost benefit of stop loss order is that it is costless, which makes it a free insurance policy.
- One does not have to monitor their trade continuously.
- This function enables one to make decisions with a clear mind.
- The traders can protect their funds aptly by using the SL order.
Risks of Stop Loss Order
- The stop-loss order sometimes leads to a slippage situation, giving traders heavy losses.
- The stop-loss order results in a more financial fiasco when the market has low liquidity.
Benefits of Taking Profit Order
- By using the TP order, the traders can keep their profits secure.
- The take-profit order lets the traders control their emotions.
- With the help of taking profit orders, one does not have to watch their trade manually.
Risks of Taking Profit Order
- Though the TP order protects a trader’s profit, it limits their ability to make more money from the same trade.
Hedging strategies are transactions locked on a fixed exchange rate today, but the transaction occurs on a future date. Forex traders in the USA use hedging strategies to protect a current or assumed position from sudden changes in the forex market. Numerous full-time investors, traders, and mega-size businesses use the forex hedge strategically to earn profits. The traders use hedging strategies to manage the long and short currency pairs against downward or upwards movements. One of the most commonly used forex hedges is the currency options method. Multiple kinds of hedging strategies in the forex industry are used per the market condition. Some of the most popular ones are mentioned ahead.
- Same Instrument Hedging
- Options Hedging
- Pair Trading
- Futures Hedging
- Forward Contract Hedging
- Assets Hedging
Like all other features of the forex market, hedging strategies have various benefits and risks. Some of these benefits and risks are as follows.
Benefits of Hedging Strategies
- Traders can use hedging strategies to lock their profits.
- It allows the traders to survive when the market goes down.
- The accurately used hedging techniques save traders from sudden changes in the price of commodities, changes in exchange rates, inflation, and various other financial changes.
- Hedging is a time-saving activity as it doesn’t ask long-term traders to watch their portfolios regularly.
- Hedging strategies can be used appropriately to maximize profits.
Risks of Hedging Strategies
- Hedging strategies cost a lot of money to traders.
- The risk control done by the hedging techniques also limits the potential profits.
- Short-term traders do not get much benefit from hedging strategies.
- Hedging is of no use when the market situation is stable.
It is a hedging technique traders use to distribute their investments in various forex instruments. The chief aim of diversification is to reduce the risk of loss in multiple trades that would react differently to an event. Professional traders use diversification to reach their long-range goals with minimal losses. There are numerous ways of diversifying your forex trading portfolio; some of the most common ones are mentioned ahead.
- Buy Mixed Currency Pairs: In forex trading, diversification means investing in currency pairs with different risk factors.
- Adopt Different Trading Strategies: To reduce the similarity between the trades in your portfolio, you can use different strategies or mix some to generate new execution patterns.
- Trade in Different Sessions: The price of currency pairs behaves differently in different time sessions, and experimenting with the time slot may provide traders with fresh opportunities.
There are various advantages and disadvantages of diversification in forex trading. Some of the most significant benefits of diversification are mentioned ahead.
- The traders can achieve long-term financial goals.
- They get to trade with multiple asset classes.
- Diversification keeps the funds safe.
- It negates the impact of volatility.
- Reduces the monitoring time of the traders.
Along with multiple benefits, diversification also has some risks mentioned ahead.
- Diversification increases the traders’ chances of mistakes, sometimes leading to more errors.
- Investing in different asset classes means investors must remember different rules.
- The traders have to bear the high cost of investment.
- Diversification limits a trader’s potential to make high returns.
Monitoring and Adjusting Risk Management Strategies
Although there are millions of forex traders worldwide, only a few can be called truly successful, as forex trading is a highly complicated financial practice. Multiple risk factors cause heavy financial losses to traders. All this uncertainty makes risk management strategies crucial to success in the forex industry. Risk management limits the losses of traders significantly and gives them a chance to have stability in such a shaky market. With management strategies, one can reduce losses and protect profits. It also makes a trader more emotionally stable, enabling them to deal with greed, impatience, and impulse. Here are some crucial tips for adjusting risk management strategies based on market conditions.
- Forex traders in the USA are advised to educate themselves about the dynamics of the forex market to remain updated with the market condition.
- Always use the stop loss and take profit orders to minimize losses and secure profits.
- Never risk more than you can afford to lose.
- Always be cautious while using the leverage feature.
- Diversify your portfolio by investing in multiple currency pairs with different risk levels.
On a concluding note, we can say that risk management techniques are essential if traders are looking forward to making a stable career in the forex industry. The forex trading market’s various aspects, like volatility, leverage, forex exchange platforms, and asset classes, must be managed properly by the traders to succeed. There are multiple risk management practices that the professionals of the FX market use to execute successful trades.
Some critical factors of forex risk management are the stop loss and take profit orders, hedging strategies, diversification, position sizing, and leverage. Forex traders in the USA who do not want to do all the hard work of risk management by themselves can sign up with reputed forex brokers USA that will take care of their funds by investing for them strategically. We highly recommend forex trading with sound risk management principles to avoid misfortunate financial losses.