How can you manage the risks in forex trading?
The forex market offers potential for making profits, but it is also very high risk. With a margin trading account, you can gain exposure to foreign currency up to 50 times your initial investment. This makes risk management an essential part of leverage trading.
Here’s how leverage trading works. If you use a leverage of 50:1, you would need to put up $1000 of your money to enter into a trade that involves $50,000. A small positive change in the value of the currency in which you have made a trade, would give you a return that can be quite significant to your original capital outlay.
However, that is only half of the story. If the market moves in the opposite direction, your trade would result in a loss. As you are using an extremely high leverage, your loss would also be magnified 50 times over. While the relative value of currencies typically moves very little over a day, your losses can easily exceed your original capital in a few trades.
So what does this mean for forex traders? It means risk management is key to any investor using leverage in their trade.
Traders: Here’s your benchmark for forex trading.
Implementing your stop loss strategy
For a start, placing a stop loss order is an essential part of your forex trade. How does this work? At the time that you enter a trade, you should also issue instructions to close your position if the trade moves by a certain value against you. By doing this you have effectively “stopped” your loss from exceeding a certain amount.
In certain circumstances, the stop loss could work against your interest. Say, the trade that you have made moves in the opposite direction of what you had expected and your stop loss order is triggered, your trade will be closed at a loss. If the market then reverses direction and moves as you had initially anticipated, you would have missed the move.
Why should you place a stop loss at all? Would it not be simpler to monitor the market and close the trade when you think that there is little chance of turning a profit?
While it is possible to adopt this approach, it is not advisable. You may not have the discipline to close the trade when losses start mounting.
In times of extreme volatility, with political events or announcements, the market might sudden gap up or down. These unpredictable moves, can cause huge losses if a trader is exposed in the opposite direction. Unique stop loss orders, called guaranteed stops, can also ensure that your losses will never exceed the level you specified. This means that even when the market gaps, you will be closed at the price you specified your guaranteed stop, with no slippage.
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Selecting an appropriate lot size
As leveraged trading has its risks, it is important to choose a lot size that suits your risk appetite. A a standard lot is 100,000 units of currency. If your broker allows you leverage of 50:1, you would need to put up 2% of the total value of the position that you want to take. This means that if the currency you are trading is the US dollar, you could be risking US$2,000 on a single trade.
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Set realistic goals for yourself
Forex trading is a high risk form of investment. If you happen to make good returns on a few trades in a day, you could get carried away and think that every trade will go your way. In a situation like this, you might be tempted to take bigger risks, and risk losing your capital in a single large trade.
How can you prevent yourself from getting into such a situation? Do not set high profit goals for yourself. In fact, if you are a beginner, it may be a good idea to have a goal of breaking even. Adopting this strategy will allow you to familiarise yourself with the intricacies of trading.
Vital features you’ll need for forex trading.
Forex trading using CFDs
There are various ways of getting exposure to foreign exchange markets. One flexible way would be to use a contract for difference (CFD). A CFD can gain you exposure to the underlying asset (currency pair), and you’ll exchange the difference in value of the currency pair between the time you open your position and the time you close it.
Forex CFDs, are usually commission free(except trades through DMA). The only charge you’ll pay is the dealing spread, plus funding adjustments to reflect the effects of interest, if you hold your position for more than one day.
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(by revenue excluding FX, 2016)
Keep your risk level to the minimum
If your broker is offering you the opportunity of leveraging your investment a hundredfold, it is not necessary to use this facility to the maximum. Instead, you should limit your trade to an amount that fits in with the level of risk that you are willing to bear.
A good rule to follow is to risk only the amount that you can afford to lose. It is also useful to maintain a trading journal. You should keep a record of your gains and losses and the thought process you went through when you entered into the relevant trades. This will help you to learn from your mistakes and ensure that you do not repeat them in subsequent trades.
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This article was sponsored by IG, the world’s No.1 CFD provider (by revenue excluding FX, 2016). All views expressed in the article are the independent opinion of ZUU.