06 May 2023

How much ‘risk’ in forex is too much?

By  Prasad. K

06 May 2023

How much risk in forex is too much?

 

Risk is a part of life. Most say any new step in life is fraught with risks. Despite this fact, there are people who grow in life. This is because the desire to succeed in a goal far exceeds the fear which comes with almost every step towards that goal. Take for instance, forex trading. Though forex trading is rewarding, there are many myths around it. One of those myths is that it is a highly risky enterprise and without looking into the details, some investors decide to stay away from it. However, despite risks, which are always present in all walks of life, forex trading done through safe and responsible forex brokers using online forex trading platforms can be very remunerative. Let us try to understand important risks in the context of forex trading.

 

There are two risks in any trading activity. First is the risk of permanent loss of capital and second is the risk of underperformance. In forex trading most traders are worried about the first risk. Loss of capital does not happen overnight if one is prudent in his or her approach while trading. Each trade undertaken by a trader comes with a clearly stated target and a stop loss. Let us say the USD/EUR trades at 0.9087. Then, a trader purchasing the pair may see a target of 0.95 with a stop loss of 0.88. In such a trade a trader may incur a huge loss if and only if she does not stick to her well-defined stop loss. If a trader closes her long trade at 0.88, then her loss is around 3 points multiplied by her volume. In addition to this, if a trader is using leverage or borrowed money for trading, then accordingly her losses increase.

 

Many smart traders avoid a situation of too much risk in forex trading by sticking to a clearly defined loss percentage on their capital. For example, if you have a capital of US$5,000 and you decide to risk 5% of your capital in a trade, then the maximum loss you should be prepared to book should be capped at US$250. So, if a futures lot comprises 25 units of underlying security, then you should ideally be trading only ten lots with a stop loss of 1 point. In case, you decide to keep stop loss at 2 points, then you should be trading five lots. In case you have a capital of US$ 20,000, then you can trade a maximum of 20 lots with a stop loss of 2 points. The above yardstick of 5% is a random number for the purpose of explaining the concept.

 

Each trader has a varying quantum of capital. While a few may start small with US$1000, there would be some large traders who would be trading with a capital of US$ 1 million. The risk-taking ability of a trader also dictates the maximum loss he or she can take on each trade. Not all trades hit stop losses, but a series of stop losses can cause a large drawdown or a large depletion in your capital. This can be unnerving. If a trader has a clearly defined stop loss in terms of a percentage of capital she has then she is more likely to be successful. The reason being: She is aware that a well-defined trade strategy won’t generate losses forever. Many seasoned traders use 2% of their capital as a stop loss when they start trading using a new strategy.

 

Beginners in the trading world may use such a similar stop loss or a stop loss that suits their risk appetite. But there is a word of caution: Most trusted forex brokers always advocate that the stop loss should not be too small. For example, while buying a security at a price of 100, ideally a stop loss at 99 is too close if you have a target of say 110. A too tight stop loss is more likely to get hit. Many a time, traders prefer to trade with a risk reward ratio of 1:2, 1:1.5 or 1:3. It means for one unit of risk, they may be eyeing for a reward of two, one and half or three units, respectively. In the above example, where a trader is looking for a target of 110, she is eyeing for a target of 10 points, hence a stop loss of 5 points could be appropriate for a risk-reward expectation of 1:2, unless the strategy demands otherwise.

 

Following such a structured approach can reduce risk in forex trading. Prudent traders always try to shift their stop loss if a trade moves in the direction they anticipated. For example, in the above example, a trader initiates a buy trade at a price of 100 with a target of 110 and a stop loss of 95. If the price moves to say 104, then the stop loss is brought to 100 or 99. This ensures that if the market turns against the trader then the losses are reduced.

 

On the whole, a key trait which makes a trader successful in forex trading is sharp alertness. Smart traders always remain alert and trade through a reputable forex investment company while trading in forex.