Risk Management Concepts
If you do not know what you are doing and you do it anyway you are taking a risk. This rule is accurate for currency trading as well as anything else you do in life. One of the first things forex traders can do is acknowledge that there are risks associated with trading, then take action to reduce or eliminate these risks. There are several steps you can take to reduce or eliminate taking chances as a currency trader. These steps will be outlined below.
Risk capital is defined as 5% of your net liquid assets not counting possessions like houses or cars. If you have $100,000 in a liquid cash account, money market funds or IRA in liquid mutual funds, then your risk capital is $5,000. You should not open a trading account for any amount larger than this. If you do you are taking a big chance and breaking one of the first rules that financial advisers and brokers suggest. The good news is that you would likely never open an account this large to start anyway due to the 50:1 leverage or higher to trade the foreign exchange. The leverage allows you to get started with a smaller amount of money and this is one of the reasons the forex is accessible to so many people.
Traders falsely believe that money management is only related to where you set stops and how you move them to break even. This is true, however money management involves a large number of things. Two examples are having a trading system that works and demo trading that system to prove it works for you. Without these two things you can set stops on live trades repeatedly and blow up an entire live money account. Having an effective trading system that makes pips is one of the keys to successful forex trading, but it eludes many traders.
If you are not willing to demo trade, then follow that up with micro lot trading, then scale up to larger lots you will fail with most systems even effective ones. Knowledge is also good money management. When you complete this beginners course a complete discussion of money management is available in the intermediate level forex course.
Risk Reward Ratio
Risk reward ratio is the amount of pips you expect to make divided by your initial stop for each individual trade entry. If you expect to make 100 pips on a trade and have a 25 pip initial stop your risk reward ratio is 4 to 1 which is very good. If all of your entries have this ratio, even with 50% accuracy you can become a millionaire. If you scalp the fx market you will fail, the math simply does not work based on the number of pips you expect to make. So higher risk reward ratios lower you overall risk and scalping increases your overall risk of entry.
Leverage by itself is not risk, but leverage allows traders with less funds to open live trading accounts with smaller amounts of money. Sometimes this attracts traders use the leverage as a license to do what they want, instead of imposing strict trading rules. Leverage of 50:1 means there is a 2% margin amount, which is the amount you have to put up out of your live funds to trade with. As long as you have an effective trading system and use reasonable stop orders leverage should not be a problem. But since so many forex traders do not have an effective trading system accounts can start to blow up pretty fast. So instead of blaming the leverage for a lost account, we think it is more accurate to get an effective trading system and to demo trade your way to success.
When you enter a real money trade the only risk you take is the amount of your initial stop price, this is your transaction risk. If the trade proceeds in your favor and you move your stop to break even you now have a zero chance of loss. At Forexearlywarning we tell traders to verify their trade entries in the main trading session with real time indicators like The Forex Heatmap®.
Along with verified trade entries, trading in the direction of the trends of the market reduces risk further, and trading early in the trend cycles take your risk reward ratio strongly positive in your favor. Transaction risk can be dramatically reduced or eliminated with these tools and techniques. Other traders are trading blind and taking big chances at the point of entry because they use technical indicators. Other risk management techniques like adjusting the number of lots traded can be employed to reduce risk if you see a more risky trade entry. All trading systems have risk. Compared to the alternative systems available to forex traders, the Forexearlywarning system is the lowest risk trading system available in the forex industry.
When you complete this beginners course, a complete discussion of entry management and risk management techniques is available in the intermediate level course, the 35 forex trading lessons.