In the fast-paced world of foreign exchange, risk management is crucial. It offers a structured way to handle uncertainty, protect capital, and improve the chances of successful trades.

In this guide, we’ll cover:

Types of risks in forex trading

Market risk in forex trading refers to the volatility of a currency’s value. Price fluctuations in forex are often driven by economic data and geopolitical factors. For example, changes in interest rates can impact a currency’s attractiveness, leading to shifts in demand and supply and therefore, price. 

Leverage risks arise when traders use margin accounts with limited capital to access larger positions. While this can offer opportunities for higher profits, it also means that unfavourable market movements can lead to significant losses. Traders can calculate their capital requirements based on their chosen leverage with a margin calculator

Forex liquidity risk refers to the ease of buying or selling a currency pair without affecting prices. Insufficient market participants or low trading volumes can result in potential slippage and unfavourable executions. While most major and minor currency pairs are liquid, some exotic pairs with lower trading volumes may pose this risk.

Insufficient understanding of the forex market and emotional factors such as fear, greed, impatience, and overconfidence can cause traders to disregard risk management principles and make poor decisions, increasing their chances of losses.

Forex risk management tools

How can traders mitigate these risks? Effective risk management involves using a combination of different strategies.

When trading CFDs, a stop loss order limits potential losses by closing a trade at a set price if the market moves unfavourably. Conversely, a take profit order automatically closes a trade when the price reaches a predetermined profit target. These orders enable traders to manage risk without constant monitoring and manual trade closures. 

On the Deriv MT5 platform, traders can input these levels both when creating an order and by modifying a position after it has been opened. 

Stop loss and Take Profit functions on Deriv's MT5 platform
Stop loss and Take Profit functions on Deriv's MT5 platform

Position sizing is the process of determining how much capital to allocate for each trade. This helps ensure potential losses are kept within acceptable limits depending on the trader’s risk appetite. 

Good position sizing practices include:

The appropriate position size is not too small to severely limit profits but also not too large to blow up your account on one trade. Finding the right balance takes practice, like any aspect of trading. Over the long run, position sizing may help manage risk and maximise returns.

Diversification is the process of spreading trades across multiple, lowly correlated currency pairs to reduce overall portfolio risk exposure. The key benefit of diversification is that it helps mitigate risk if one pair performs poorly, as losses in one currency may potentially be offset by gains in another. Traders should aim to diversify across major, minor and exotic pairs that are not highly correlated. For example, pairing the major EUR/USD and GBP/USD together provides limited diversification since they are positively correlated. But adding exposure to uncorrelated exotic pairs like USD/TRY or USD/ZAR provides better diversification. 

The diversification principle can be taken a step further when constructing an optimal portfolio of positions across asset classes, not just currency pairs. Many traders analyse correlations between currencies, stocks, commodities, and other assets to build a portfolio with the highest return for a given level of risk.

Continuous education is also crucial for reducing trading risks. By regularly updating market knowledge, traders cultivate a mindset of adaptability and continuous improvement. This concept of ongoing development is especially essential when building trading plans. 

How to make a forex trading plan

A forex trading plan is a comprehensive roadmap that guides investors on how to trade currency pairs with discipline and focus.

Traders must first set clear goals aligned with their financial objectives, risk tolerance, and available resources. Then, choose a preferred trading style (e.g. scalping or swing trading) and timeframe. Finally, they should define entry and exit points based on indicators, chart patterns, or analysis. Risk management tools should also be incorporated throughout the plan.

Evaluating performance

A successful trading plan requires regular rigorous evaluation and ongoing refinement. Traders must continuously analyse both winning and losing trades in detail to identify patterns, strengths, and specific areas for improvement. This performance evaluation should go beyond just net profit/loss to include key metrics like risk-reward ratio, profit factor, drawdowns, and Sharpe ratio.

These statistics need to be monitored over different time frames — daily, weekly, monthly, quarterly, and annually to assess consistency. Traders should compare performance across different market conditions, asset classes, and time periods to determine optimal strategies for various environments. An honest assessment of mistakes and missed opportunities is crucial to boost future performance. 

Traders should set concrete, quantifiable goals for improving risk metrics. Comprehensive trade journals can aid evaluation by recording detailed analyses, market conditions, and lessons learned from each trade. Finally, sharing performance with a mentor or trading community provides an outside perspective. 

Traders can also initially test their strategies on a free forex demo account. This replicates the experience of live trading, with 10,000 USD virtual funds allocated to the account. 

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Using risk management tools and sticking to a well-defined trading plan can increase the likelihood of successful forex trades while minimising the impact of adverse market movements. Ongoing evaluation and refinement is the key to elevating trading skills over time.

Disclaimer:

The information contained in this blog article is for educational purposes only and is not intended as financial or investment advice.

Deriv MT5’s availability might depend on your country of residency.