The high rewards in the forex market are coupled with equally high risks. More that any other financial markets, the forex market has very high liquidity in major currencies supplied by International Banks and Hedge Funds, however it can become illiquid at times due to shifts in supply and demand of currencies making it extremely volatile under those circumstances. A trader can take many steps to minimize many forms of unnecessary risks. Here is a small list of risk management tips that every responsible trader should adhere to.
Whether you are an investor (for me that's not a time frame; it is a move greater then 4%) or speculator (I do define that as time frame, being 1-3 days) in the forex market, the most fundamental step that you can take is to educate yourself. Every trader should do ample research before venturing into currency trading, one, to understand the risks involved, and two, understand if your personality fits this trading arena. Making well-informed decisions and executing effective strategies will minimize risks, increasing your chances of success in trading. One important way you do this is with the use good money management. I will give an overview of two professional money management techniques in the up coming paragraphs.
Let's first go over trading styles, there are two forms of trading in the forex market: technical trading and fundamental trading. Technical traders tend to focus on the technical behaviors of the currency market, buying and selling based on chart analysis and formulas. Fundamental traders on the other hand focus on worldwide economic, social and political moods. Most of online forex traders focus on technical trading. Although technical trading (for me) is the most effective in generating positive results, it is best to have a sound knowledge of market fundamentals as well. However, in my experience do not attempt to over analysis too much data. The more data you have, the more chance you have to drown in it. Thus a well-informed trader must strike a balance between the two forms of trading that they are comfortable with. Mine is 90% technical and 10% fundamental. Now on to the most important task in trading; and that is Money Management. I will go over a technique that I use for Day Trading, and since I am a technical trader this is the technique that I use overall.
Money Management is what keeps you in the game. The technique asks me the all important question of "how much?" How much leverage can I use to control my position. In other words what is my maximum position size to my risk amount. It is a bit complex, but, I will give you the frame work here to start off with.
The technique that I use is called the Base Equity Method. The Base Equity method is a predetermined percentage that you allocate to each position. It then deducts that amount from your over all equity, until the position (or positions) are closed. I do not exceed a maximum of 5% of my base equity on anyone trade. As a matter of record I do not exceed 4.5 %, and build up to that when I am winning. Let's go over an example.
I will start off with a $25,000.00 account for our example. You decide that you will risk 4% risk per trade. You base that on a number of factors, the least not important your psychological makeup. Let's enter the trading process. You first must calculate "how much" you can trade. Here is the Math
$25,000 * 4% = $1000.00 Stop Loss (You now have $24,000 left to trade with, and your next position s/l calculation will be 4% of $24,000. If you capture a $3000.00 profit your account s/l is calculated off of $28,000.)
It is from this point that it all begins, you then have to calculate your risk reward ratio to see what size of a position to open and how many pips are you forecasting to capture. Also how many pips do you need to whether the storm of a counter move against you? Sorry to say guys, size does matter even in forex.;-) It is this analysis that tells you if the reward is worth the risk.Very Important stuff to know. Do not be flippant about it.
If we are going to trade on Fundamentals (not recommended) I would use a technique called "Portfolio Heat". In my opinion if you are going to trade fundamentals you need to constantly be in cross currency trades (EUR/JPY, CHY/JPY for example.) The object being to open one leg of the cross (legging out) to take advantage of economic events and news. The Portfolio Heat Method measures how much you need to start unwinding, and at what levels.
Although online brokers offers a credit line where traders can trade up to 400 times the amount of capital they have in the account. Marginal trading can yield very high rewards but the risks involves are also considerable. As a general rule, it is best to trade within the limits of the capital in your account (Base Equity). Traders should resist the temptation of marginal trading (Position to large, and, Over Trading as well) as one small slip could easily wipe out your capital and subject you to a margin call.
