FX trading involves risk as the market may move against our expectations and result in loss. In term of trading, the probability of losing money is defined as risk. Taking on risk is inevitable; however, it is vital to keep your capital from risks that can ruin your entire account. Thus, we need to identify, control and mitigate associated risk by a set of rules known as risk management, which aims to master two concepts: cutting your losses short and letting your profits run.
As a mathematical rule, the larger losses require greater profits to recover your balance. For instance, if you lose 10% on your balance, you need to gain 11.1% to recover your initial capital. This ratio increases significantly as the losses percentage increase. If you lose 50% of your money, the required profit will be 100% to cover your loss.
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Risk management is the most essential part of each trading system that can keep you from stopping out and help you having confident trades. Let's take a look at the main steps to help you apply proper risk management in FX trading.
Although market participants have different risk appetites depending on their trading style, preferred time frames, and financial goals, it is essential to determine how much money one is willing to lose before entering a particular trade. It is recommended not to risk more than 3% of your equity on any single trade, and don't risk more than you can afford to lose. It means, with equity of €5000, the maximum risk on each trade should not be more than €150.
Using stop-loss is a critical element of risk management. It means you should know where to exit a losing trade to protect your account against excessive losses. Moreover, stop-loss makes you able to identify your potential losses called pips at risk, which is the difference in pip between the entry price and the stop-loss price. For instance, when you are going to buy EURUSD at 1.19500 and place the stop-loss at 1.1930, you have 20 pips at risk for this trade.
Position sizing is a sort of calculations that lead to taking optimal units on a trade due to your risk limit and the trading set up. For instance, with a risk limit of €150 and 20 pips at risk, the proper position size to buy EURUSD at 1.19500 is figured like this: Risk limit per trade / Pips at risk = 75000 units of base currency or 0.75 lot.
Another essential step in risk management is following a specific risk to reward ratio to measure where to lock in profits in advance. The risk to reward ratio indicates your potential reward for each dollar you put at risk. Following a 1:2 risk to reward ratio means a stop-loss of 20 pips signifies a take profit of 40 pips.