If you want to be a successful Forex trader, you are going to have to learn how to manage risk. In FX trading, there is only one risk that you need to worry about – losing money. While this may seem like a rather obvious point, risk management is in fact one of the most frequently overlooked disciplines in the world of Forex trading. Most traders treat the currency markets like they would a fruit machine – they just work out how much they can afford to lose, and hit the trade button. However, if you want a long-term return on your investment, you are going to have to get out of this type of jackpot-seeking mentality. While there will always be a few people who win big at the casino, the majority of punters end up going home empty-handed. As the saying goes, the house always wins. They manage to stay in business by maintaining a statistical advantage over their many customers. It is this type of advantage that you need to cultivate if you are to be a successful Forex trader.
In order to gain this statistical advantage, you need to adopt a strategy to control your losses. However much faith you put in your judgement as a trader, nobody wins 100% of the time. Even if you won 90% of the time, if you invested too heavily in the 10% that you didn’t win, then you would still potentially be running at a loss. This is where risk management comes in. By applying a strategy of investment that is independent of your intuition as a trader, you can stay in the game even when that intuition proves to be way off. By controlling your losses, you can increase your chances of being profitable over the longer term.
One of the simplest, and most effective, risk management techniques is to stake smaller amounts. Let’s say, for example, that you have $20,000 in your trading account. If you were to risk 10% of your account each time you traded, and you made 19 losses in a row, you would be left with just over $3,000 in your account – a loss of 85%. However, if you had risked 2% of your $20,000 on each trade, and you went on the same losing streak, you would still have nearly $14,000 in your account – a loss of just 30%. So, you can see the difference that risking a smaller percentage of your account in each trade can make to your bottom line. If you lost 85% of your account, you would have to make a profit of 586% on the remaining amount in order to get it all back - no mean feat, especially for a trader who has just made 19 wrong judgements in a row. Of course, 19 losses would be an exceptionally unlucky streak, but it does happen, and even if you only lost a few trades in a row, the same principle would apply.
The more money you lose, the higher the percentage of your remaining money you will have to stake in order to break even. For example, if you were to lose 50% of your capital, then you would have to stake 100% of your remaining capital in order to break even, and if you lost any more than that, you would have to put in more of your own money just to have a chance of breaking even – a tactic known as ‘chasing your losses’. Needless to say, this is not the best way to strike it rich on the Forex market, but you might be surprised at how widespread this practice is among traders, especially novices. The only way you can survive losing streaks and give yourself a good chance of being profitable over the longer term is to risk smaller percentages of your account on each trade.