No matter your level of experience in forex, trading currency pairs will always be risky. However, you can help hedge inevitable losses by setting up a risk management policy.
Test Your Trading Strategy
Prior to live trading, you should test your strategy by using back-testing. Also, be sure to frequently utilize price charts throughout your preparation. These processes allow you to calculate the success rate and determine the volatility of any given trade.
If you are uncomfortable with these outcomes you should consider managing risk by assessing an exchange’s liquidity, your leverage, and the capital you are willing to trade. Decisions on these elements influence risk by altering the success rate and volatility.
Measure Liquidity
The safest currency pairs in forex have high levels of liquidity. For example, EUR/USD is the most liquid as it is exchanged more than any other pair.
Meanwhile, trading pairs with low levels of liquidity can be dangerous. You may not be able to enter or exit at the intended price if the exchange is rare. Your order to sell can easily fall through, especially if the price is volatile. If this happens you can end up losing way more money than you intended.
Looking at the spread (the difference between the bid and the ask) is a good way to measure liquidity. Pairs with high trading volumes tend to have tighter spreads.
Make sure you understand the typical liquidity between two currencies or else you may be blindsided with major losses if your trade does not execute.
Using Leverage
The forex market can be enormously leveraged due to its great liquidity. Leverage is spending money that is not your own, and in forex this is typically a broker’s cash. You usually can trade with 10 or even 100 times more capital than you deposit.
Leverage magnifies both gains and losses. If you are an extremely confident forex trader, then it might make sense to lever up and put more money in play than you have. However, if you are more risk averse, using little to no leverage may be appropriate as you do not want to accrue drastic losses or debt.
2% Rule
Another tactic in mitigating risk in forex and other markets is the 2% Rule. Traders following this policy know to never put up more than 2% of their capital on any single trade.
The 2% Rule ensures protection from a failed trade, as your account takes a smaller hit. Forex traders sometimes break this rule, but it can be risky. If you are concerned about the risk of your exchange in any way, add the 2% Rule to your strategy.
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Consider all of these factors while setting up a forex risk management policy. It is important to be confident in your speculation, but never risk more than you are willing to lose.
