Forex risk management involves a combination of responsible use of leverage, appropriate lot size, correct placement of a stop loss order and a profitable risk/reward ratio. When used correctly, all of these ingredients are combined into a recipe that does not risk more than 1-2% of your trading account for any single trade.
Leverage allows you to use a small amount of capital in your trading account to control large amounts of capital in your trades. If a forex broker offered a leverage of 200:1, it would only take a deposit of $50 to control a $10,000 trade. Likewise if a broker offered a leverage of 400:1, the same $50 deposit could control a $20,000 trade.
Forex leverage can be a double edged sword – it can work for you by amplifying your wins, or against you compounding your losses. Just because a broker offers high leverages of 200:1 or 400:1 doesn't mean that you should use it all the time. When you are new to trading, a leverage of 20:1 or 50:1 is much better than a higher leverage.
Lot sizes determine the dollar value of each pip. Micro accounts offer $1000 ($0.10 per pip), mini accounts offer $10,000 ($1 per pip) and regular accounts offer $100,000 ($10 per pip) lot sizes. These pip values are based on trading EUR/USD.
Think of a stop loss order as trading insurance. Just as you wouldn't drive without auto insurance – you shouldn't trade without a stop loss as insurance against excessive losses. Correct stop loss placement is based on the trade entry, areas of support and resistance and risk/reward ratio.
A trade's risk/reward ratio determines whether you should take a trade or wait for the next trading opportunity. The bare minimum risk/reward ratio is 1:2. In other words if the risk is 20 pips then the reward should be 40 pips. A risk/reward ratio of 1:3 would be a risk of 20 pips and a reward of 60 pips. Proper risk/reward ratio will allow you to be wrong 50% of the time and still be profitable.
Let's look at an example trade using EUR/USD that follows sound risk management. We have determined that the overall trend is up so we are looking to go long (buy). We determine we want to buy at 1.3500. The last low point was at an area of support at 1.3480 which is 20 pips lower. We can see that the next area of resistance is 40 pips higher at 1.3540 which will serve as our target.
We have a micro account balance of $10,000 and we are using 50:1 leverage which would allow for a trade of 5 regular lots or a position size of $500,000. However, we want to use sound risk management so we only want to risk 2% of our trading account for this trade – 2% of $10,000 is $100. With a stop loss of 20 pips that would mean we could trade a position of $5000 – $5 per pip x 20 pips stop = $100. We place a limit order to trigger at our target of 1.3540 which is 40 pips. 40 pips x $5 per pip = $200 or a risk/reward ratio of $100/$200 or 1:2.
Trading forex carries with it a high level of risk – but it doesn't have to be “risky” as long as you use solid forex risk management. Make protecting your account balance a priority over making a profit and you will find your account balance steadily increasing even with a number of losses.