How to Reduce Risk When Trading Forex: Ten Risk Management Ideas

It must be said that no matter how careful you are, you will never fully eliminate risk from the forex market. Yes, I can help you mitigate your risk if you read on, but there’s no such thing as risk-free forex trading. Anyone who tells you otherwise either has a time machine or is not to be trusted.

I should also remind you that, yes, risk is indeed something to avoid. Too many novice traders think successful forex traders are the bold ones, those who spot an opportunity, yell “I’m all in!” and make monster bets on one currency or the other. No. Successful traders are most often the grinders. They’re the ones that control the risks as much as they can, take calculated gambles, limit their losses, and let their winners run. 

Being a grinder might not sound quite as exciting as being an all-or-nothing gambler, but if you’re serious about making money in forex markets, you’ll learn to manage risk and make intelligent trades rather than look for a get-rich-quick strategy. Here’s a few forex risk management tips to get you started:

#1 Learn the forex market 

This should go without saying, but I’m always surprised by how many new forex traders hop into the market without any form of expertise. And in my experience it’s the forex traders who know the least that take on the most risk. The forex market is complex, but not beyond your understanding. 

There are so many good sources for information on forex trading available to you. Podcasts. Books. YouTube videos. However you learn best, there are resources available, and most of them are very cheap, if not free. Even if you’re getting investment advice from someone you trust, take the time to learn the forex market on your own. 

#2 Choose the right forex broker

This is a very simple step you can take before you even begin trading foreign exchange. There are a lot of forex brokers out there, ranging from the scam artists who claim to be brokers in order to run off with your initial investment to the heavily regulated brokers who answer to multiple government agencies and have to account for every penny you deposit. 

I encourage you to read my much longer post on how to choose a forex broker, but I’ll just give you the basics here. To start, check with the financial regulatory bodies in your country of residence to verify that your broker is in compliance. In the US, you can check with the CFTC (Commodity Futures Trading Commission) and/or the NFA (National Futures Association).

After you’ve determined that the broker is legit, read professional reviews and read what other traders are saying. Even some regulated forex brokers might not have your best interest at heart. Find a broker that offers you security, cheap trading costs, quick trade execution, a trading platform you’re comfortable with, and easy withdrawals. A forex broker that you can trust eliminates a lot of risk from the start. 

#3 Practice forex trading with demo accounts

We learn how to ride a bike by starting off with training wheels. We learn how to swim with floaties or inner tubes. Whenever we learn a skill that involves risk, we do so gradually and in a controlled environment. 

Forex trading should not be an exception. 

Almost every forex broker offers some sort of demo trading account (also known as a “paper trading” account) that allows you to learn the mechanics of making trades, lets you experiment with a new trading strategy, and helps you familiarize yourself with the trading platform. Experiment with both the mobile forex trading apps and the desktop trading platforms and become proficient in both. You can perfect your trading skills without any risk, which will leave you infinitely more prepared for diving into the real market when you’re ready.

When you practice entering trades in a risk-free environment, you minimize the risk of making a mistake with real money. You’d be amazed at how much “fat finger” trades or other simple errors when entering a trade can cost you. 

Of course, success with a demo account does not ensure success in the real market, but it will give you the technical experience that will help you eliminate the risk of unforced execution errors that can doom many traders.

#4 Don’t trade more than your allocated risk capital

Risk capital simply means the money that you can afford to lose. Unfortunately, Hollywood-type stories about a trader who bets his last rent money on a single trade that somehow hits and makes him rich enough to buy his whole building just don’t happen very often. Desperate traders make desperate trades, which is a recipe for failure. That’s why you never trade with more than you can afford to lose. 

To determine your risk capital, make sure your obligations are accounted for, put money aside for a rainy day, invest in some low-risk assets, and then allocate some of what’s left to be your trading capital. 

The one mistake traders make with this approach is that they seem determined to lose the money that they can afford to lose. Just because you can lose that money, doesn’t mean you should! If you’re overly speculative with your risk capital, it will be gone before you know it. Treat your risk capital like it’s your rent money, but for goodness sake, never trade with your actual rent money.

#5 Use stop losses

This is the simplest way to exercise risk management, take control of your trade, and limit your losses. When you open a position, always do so with a stop loss in place. 

A stop loss does exactly what you’d think from its name. When you enter your trade you can set up a level below your purchase price. When your position reaches that level, your broker automatically closes your position. That way, you know in advance the maximum amount you could lose. 

To use a simple equity example, if you buy 100 shares of XYZ Corp at $10, and set a stop loss at $9, the most you can possibly lose is $100. Should XYZ Corp dip to $9 a share, your broker automatically closes the position at that price. By limiting your losing trades, you can always live to trade another day.

Stop losses are particularly useful if you’re trading on the go, or if you are for some reason unable to monitor the market as closely as you’d like. 

It is important to note that stop losses aren’t infallible. Especially in volatile markets, your broker might not be able to close out your position at exactly your loss limit, but good brokers always come close.

#6 Use take profits

A take profit is basically the opposite of a stop loss. When you set a take profit, your broker will automatically close your position once your trade has made a certain amount of money. This might seem a little counterintuitive. How does limiting your profits also limit your risk? 

Experienced forex traders will tell you that a lot of good trades become bad trades in a hurry. If you’ve got a winning trade, it’s human nature to stick with it as long as you can. No one wants to kill their golden goose. However, the value of your position is just as likely to reverse course as it is to continue in your favor.

A take profit eliminates the risk of a good trade going bad by locking in your profit and preventing you from getting too greedy. Like stop losses, take profits aren’t always executed at exactly your price, so keep that in mind when you’re making your trade.

#7 Keep a close eye on the economic calendar

The forex market can move very quickly and very erratically in the face of unexpected news. Some of this you can’t control, of course. A pandemic or declaration of war can throw markets into disarray without any warning. These unpredictable global events are part of what makes forex trading so risky. These are the risks you can’t control or trade around.

However, a lot of news items that affect the forex market are scheduled well in advance. Typically we know when the Federal Reserve or the Bank of England is going to meet and make announcements about interest rates. We also know when unemployment figures or other economic data are going to be released. Stay on top of the financial news, particularly the news that’s going to affect the currency pairs you typically trade. If you don’t want your money to go for a wild ride, close your positions before any big announcements. 

#8 Understand leverage and how to use it

Leverage is one of the big reasons traders are attracted to the forex market. You can take sizable positions with very little money down. Make a good trade and leverage will magnify your gains many times over. Make a bad trade and you can easily lose more than you initially put down. 

Depending on your broker and which country you live in, you can trade forex with anywhere from 20:1 up to 200:1 leverage. If you’re trading with 200:1 leverage (most likely with an offshore broker since most regulated brokers can’t offer leverage that high), that means for every dollar you have in your account you have $200 to use in the market. That sounds great, but it can easily work against you.

A simple example with 200:1 margin: If you open an account with $1,000 you could take a position worth $20,000. If your position moves against you by just 1%, you lose $200, or 20% of your account. Don’t be seduced by the benefits of leverage without considering the risk involved. 

#9 Have a trading plan

One of the first pieces of advice you’ll receive from most successful forex traders is to not trade emotionally. Why? Because emotions can often get the best of you. A bad trade can ruin your confidence and make you hesitate on the next opportunity. A good trade can give you too much adrenaline and make you overeager to take on new positions even if the market isn’t presenting good opportunities. Even boredom, an emotion most traders don’t talk about, can lead you to make ill-advised trades just for something to do. 

What’s the best way to eliminate emotions and the risks that they exacerbate? Have a specific trading plan that guides when you enter into a trade and when you exit. Stick to the plan. If the plan needs to be adjusted, do so away from your trading platform so that you’re not simply using a new plan to justify more trades.

#10 Don’t keep positions open overnight or over weekends

You plan on sleeping don’t you? Because for most of the week, the forex market doesn’t. Due to different exchanges opening in different time zones, the forex market is open for business 24 hours a day, starting on Sunday at 5 p.m. EST until Friday 4 p.m. EST. 

That means news in other parts of the world could drastically change prices while you sleep. Stop losses and take profits can give you peace of mind, but if something truly drastic happens, your broker might not be able to fulfill your order right at your price point. If the last few years have taught us anything, it’s that drastic things happen quickly.

The other reason to not keep positions open overnight is that if you’re taking positions on margin, which most forex traders do, your brokerage will charge you overnight interest on the amount that you’ve borrowed. 

Conclusion

As I said at the beginning, you can never fully eliminate risk from forex trading. Forex risk management is about mitigating risks, not eliminating it. Even cautious forex traders can and do lose money. But if you put 100 failed forex traders in a room, the vast majority of them would not have followed the above rules. So practice these risk management rules and you’ll significantly increase your possibilities of becoming a successful trader.