Understanding Forex Risk Management. Trade is the exchange of goods or services between two or more parties.
So if you need gasoline for your car, then you would exchange your dollars for gasoline.
In the past, and still in some companies, trading was done by barter, where one commodity was exchanged for another.
An exchange may have gone like this: Person A will fix the broken window of Person B in exchange for a basket of apples from Person B’s tree.
This is a practical example, easy to manage, of the day-to-day conduct of an operation, with a relatively simple risk management.
To reduce the risk, Person A can ask Person B to show his apples, to make sure they are good to eat, before fixing the window.
That’s what trade has been like for millennia: a practical and thoughtful human process.
This is Now
Now enter the global network and suddenly the risk can become completely out of control, partly because of the speed with which a transaction can be made. In fact, the speed of the transaction, the instant gratification and the adrenaline rush of making profits in less than 60 seconds can often trigger a gambling instinct, to which many traders may succumb. Therefore, they might turn to online trading as a form of gambling rather than approaching trading as a professional business that requires proper speculative habits. (Learn more at Are you investing or betting?)
Speculating as a trader is not gambling. The difference between gambling and speculation is risk management. In other words, with speculation, you have some kind of control over your risk, while with gambling you do not. Even a card game like Poker can be played with the mentality of a player or with the mentality of a speculator, usually with totally different results.
There are three basic forms of gambling: Martingale, anti-Martingale or speculative. Speculation comes from the Latin word “speculari,” which means spying or looking ahead.
In a Martingale strategy, you would double your bet every time you lose, and expect that eventually the losing streak would end and you would make a favorable bet, recovering all your losses and even making a small profit.
Using an anti-Martingale strategy, you would halve your bets every time you lost, but double your bets every time you won. This theory assumes that you can capitalize on a winning streak and profit accordingly. Clearly, for online traders, this is the better of the two strategies to adopt. It is always less risky to take your losses quickly and add or increase the size of your trade when you are winning.
However, no trade should be made without first stacking the odds in your favor, and if this is clearly not possible, then no trade should be made. (For more information on the Martingale method, read FX Trading The Martingale Way.
Know the odds
Therefore, the first rule in risk management is to calculate the likelihood that your operation will succeed. To do this, you need to understand both fundamental and technical analysis. You will need to understand the dynamics of the market in which you are trading, and also know where the possible psychological price trigger points are, which a price chart can help you decide.
Once the decision is made to trade, the next most important factor is how to control or manage the risk. Remember, if you can measure risk, you can, for the most part, manage it.
When stacking the odds in your favor, it is important to draw a line in the sand, which will be your cut-off point if the market operates at that level. The difference between this cut-off point and the market entry point is your risk. Psychologically, you must accept this risk in advance even before you take the trade. If you can accept the potential loss, and agree with it, then you can consider trading further. If the loss will be too much for you to bear, then you should not take the trade or else you will be severely stressed and unable to be objective as your trade proceeds.
Since risk is the opposite side of the coin to reward, you should draw a second line in the sand, which is where, if the market trades to that point, you will move your original cut line to secure your position. This is known as sliding stops. This second line is the price at which you break, even if the market excludes you at that time. Once you are protected by a breakeven point, your risk has been reduced to virtually zero, as long as the market is very liquid and you know that your trade will be executed at that price. Make sure you understand the difference between stop orders, limit orders and market orders.