Knowing the basics a risk management is essential for profitable forex trading. In this guide I'm going to introduce you to a golden rule I like to use and neat technique that absolute beginner forex traders should use.
Let me know in the comments what risk management strategies you like using.
The 1% Rule
One way to reduce your risk in forex trading is to use the 1% rule. This is where you only use 1% of your account value to make a trade.
By using a percentage you'll have a reverse compounding effect on your account. If you make a series of losses, by using 1% of trading capital, the amount you risk will become less and less. This is a smart way to ensure that if you've made some bad trades due to your ego, at least you won't wipe out your account.
But the opposite is also true when you're making profitable trades. Over time the amount you profit will become more and more as your account balance grows and the 1% grows with it.
The mistake new traders make
A new trader might make a deposit of 1000 and then use $100 to open a new position. In this scenario the trader is risking a massive 10% of their portfolio. Remember in Forex trading you can lose your entire position (and sometimes even more).
While it may be tempting to use large amounts of capital for each trade, it's almost a surefire way of donating all your money to the broker. If a broker sees this, they might not even bother matching your trade. Because they know that you'll soon lose all your money and they'd rather keep it all themselves.
The maths behind your losing trades
Another of the mistakes new traders make is hunting for small gains of a few pips. Lets say a trader is looking to gain 5 pips. With a spread of 3 pips, you're only going to make a profit of 2 pips anyway. And if you've set a stop loss of 5 pips as well, if the trade closes you'll lose 5 pips.
So the possible profit is 2 pips and the possible loss here is 5 pips. So basically risking 5 pips just to make a 2 pip profit. And this is a situation where the maths is against you.
So forex scalping with a spread doesn't work. And for most traders this isn't going to be a profitable long term strategy. The maths is against you and over time you will need to win way way more trades then you lose in order to just cover your losses.
This is why you need a trading strategy
So instead of trying to hunt down small gains, you need to develop a trading strategy. This might involve trading less and only making a trade during a big market move. Or you might choose swing trading where you wait for the right market conditions to make a series of trades.
Whatever strategy you choose though, you should stick to the 1% rule.
Using Copy Trading for Risk Management
If you're a reader of this blog, you'll know that I always recommend copy trading for new traders. This is where you automatically copy the trades of experienced traders. It's a good way to learn.
My copy trading platform of choice is eToro and it's what I also recommend.
On eToro say you've made a $1000 deposit. With this you can copy trade 5 traders on the platform (as the minimum copy trading amount is $200). When you allocate $200 to a trader, this will be used to make the same trades the copied trader does. And these trades are made in the same proportion as the trader makes. So for example if a trader uses 1% of their account capital to make a trade, 1% of the $200 you allocated will be used to make a trade as well.
So in this situation you've used a tiny proportion of your overall account capital to open a trade. This is a great way to reduce risk. Copy trading on eToro allows you to makes lots of little trades using small amounts of capital. This is why I love eToro so much. Other copy trading platforms require you to set a minimum amount of capital to be used for each trade and doesn't use the same proportional system eToro uses. It just doesn't work as well as what eToro has.
Using Variable Leverage
When you sign up to a broker, your leverage is usually fixed. You can't change it per trade. But there are a few brokers that allow you to change the leverage you use for each trade. This can be a powerful risk management tool. Because you might want to change the amount of leverage depending on market conditions. During volatile times, a reduced amount of leverage can be a god send.
So when choosing a broker, see if they offer this feature. Yes, my fav broker eToro lets you do this.
So there you have a short introduction to risk management in forex. The basics:
- Use 1% of your account capital per trade – you might need to deposit more in order to do this (as brokers set a minimum amount per trade), but overall its a much smarter strategy.
- Don't use forex scalping with spread trading – forex scalping is an advanced trading strategy best used on brokers that have zero spreads.
- Maybe try copytrading as a way to spread the risk across a lot of trades
- Use a broker that has variable leverage.
Let me know in the comments what risk management strategies work for you.