What is Risk?
Risk is exposure. In Forex trading, risk refers to exposure to the price changes of a currency pair. Often, risk makes people wary of trading stocks, commodities, or currencies. It is true that risk is an integral part of every trade. In other words, there is no such thing as a risk free trade. If any broker says that his investment or trading system is risk free, you may be talking to an unscrupulous dealer. This is a warning sign of which all traders should be aware.
Risk is an aspect of every trade and of every traders life. Even such successful investors like Warren Buffett and William ONeill have admitted that they have lost money in the market. Every trader will lose money trading currencies. The goal, though, is to make more winning trades than losing trades, make more money than you lose, and to manage your level of risk.
Understanding risk is the first step towards managing it. The Forex market carries a uniquely high level of risk. This high level of risk comes from the high amount of leverage available to Forex traders. The currency market allows people to purchase currencies at a 100 to 1 or even 200:1 ratio. No other financial market allows this amount of leverage. Many traders are attracted to Forex for this reason. But it can be a double-edged sword. The faster money can be made, the faster money can be lost.
Levels of Risk
Different kinds of accounts carry different levels of risk. The margin account is the riskiest type because the trader has access to nearly unlimited funds. In other words, the trader is not limited to the cash available in his or her account. The trader using a margin account can end up owing additional funds if the currency pair makes a strong price movement against him. And, yes, this does happen to traders, which is why stop loss orders are always recommended.
A cash account carries much less risk because the trader is limited to trading only the amount of cash in the account. However, the risk is that the trader will not have sufficient funds available to enter the desired trades.
The Margin Account
To trade on the margin , a trader must have a margin account. A margin account is a special type of account that traders can have with a brokerage firm or bank. Margin is the required amount of money that a trader must deposit to collateralize (or fund) a Forex position. Therefore, margin changes constantly as the price of the currency pair changes. If the currency pair moves in the traders favor, the margin requirement will be lower. However, if the currency pair moves in an unfavorable direction, the trader may need to deposit additional funds to keep the position adequately funded. This is known as a margin call .
Risk Reward Ratio
A Risk-Reward Ratio is a calculation that shows the maximum amount of risk and maximum reward on a particular trade. It is one of the best factors in deciding whether to enter a particular trade. Every trader should know how much he or she is willing to lose and how much he or she is looking to gain on each trade. The risk-reward ratio should be at least 1:2. A higher ratio (1:4 or 1:6) is even better. If the Risk-Reward Ratio does not meet the minimum requirement, the trader should not enter this trade. The Risk-Reward Ratio is an excellent risk management tool and should be used by every trader on every trade.
Although risk can cause anxiety for traders, it can also be managed. Risk management tools and techniques are essential for every trader to employ. A few ways to manage your risk in trading Forex are:
- Determine Risk-Reward Ratio. Always know the amount of your exposure.
- Use stop loss orders.
- Never maximize the available margin. Keep margin use to a minimum, preferably 10 to 20 percent on each trade. Decide carefully whether to use any margin at all.
- Avoid using margin in uncertain markets.
Trading on the margin can be both risky and profitable. Understanding your risk on each trade and knowing your psychological level of acceptable risk are important ways to protect your account and yourself.