Risk Management for Forex and CFD trading
Did you know your profit or loss could be increased to a considerable extent by the leverage used in Forex and Contracts-For-Difference (CFD)? However, since the potential profit is proportional to the risk, it is crucial you understand beforehand that risk acceptance is a requirement to Forex and CFD trading.
Although Forex trading poses countless risks, it is possible to reduce them by using Forex risk management strategies. Here we will give you some basic tips you can follow to reduce your losses, but keep in mind that the information presented here is just a guide to help you, not specific advises on investment actions.
Forex and CFDs trading recommendations for beginners
General FX risks
Your profit opportunities are proportional to the comparable risks. Picture the Forex risk management as a portfolio of a diverse number of instruments that will help you to increase your potential profit and reduce your trading losses.
There are four basic principles for Forex trading risk management:
- Recognize, analyze and evaluate Forex risks.
- Find solutions to reduce it
- Manage and apply consistently the solutions solutions
- Both new and experienced traders consider the assessment of the market to be a major point in Forex trading.
However, even though it is important to know the right market position, seasoned traders regard risk management just as essential.
Forex trading leverage effect
Having access to leverage is one of the reasons people choose Forex and CFD trading due to the reduce margin requirement it offers in comparison to a full investment, i.e. you invest less to possibly gain more. Keep in mind that this also means that you could lose more.
Most of the brokers offer Forex trading leverage ranging between 25 and 500-to-one. For example at a leverage of 100-to-one, you can move 10,000 USD with a margin of just 100 USD.
Forex trading leverage offered by most of the Forex Brokers usually ranges between 25 and 500-to-one. Thus, at a leverage of 200-to-one, you can move 20,000 USD with a range of just 200 USD.
Incorrect market assessment
Forex and CFD trading depends on steadily market movements and because the spread (the difference between the bid and ask price of the forex pair) is subtracted from the order opening, all orders normally start with a slightly negative balance. Therefore, as you can see, it is hardly surprising to make mistakes and lose some profit when first starting your market assessment. Nevertheless, you can control your losses by setting a stop loss mechanism at the final level you are prepared to accept loss. Remember not to set your stop losses too narrowly; otherwise, you will get your order closed due to minimal market movement.
Do not forget that not all trades make profits.
Rapid market movements
News, views, trends and political decisions can influence the market in the blink of an eye. Here we have two examples:
- Major interest rate decisions made by leading central banks can create huge gaps on the trade chart within seconds.
- Professional market players can invest large funds to intentionally create a substantial shift in a specific market.
No matter how dutifully you manage your trading activities, you cannot predict the rapid market movements. This is why we recommend you to set up automated stop mechanisms to keep track of your orders for you. However, do not forget that the stop loss cannot entirely avoid losses; it will just tell you when you can take actions to reduce them.
You can see the significant leap in prices of the trade marker on a trade chart. For the most part, these gaps occur when the market are closed, but in the presence of unexpected economic news that make trading orders to close far from the preferred threshold, even open markets can be affected. This is something you have to consider because even automated stop mechanism cannot close orders until the next available quote after the jump. For example, here we have the EUR&USD chart:
- Unusually large gap after a weekend in July 2015
- No prices shown inside the gap, making impossible the activation of stop mechanisms before the next manageable market price.
Additional Forex and CFDs risk management alert
The gap illustrated in the Forex trading terms are based on negative slippage, however, it is possible to have a gap this size with a positive outcome, for instance, a scenario where the profit you make is higher than the preferred take profit would have produced.
Forex Risk Management Tools: Stop-Loss
Stop mechanisms are one of the most important Forex risk management tools. Why? Because they usually react quicker than a human trader does, and since quotes can shift fast (even shift faster in an unstable or nervous market) this is an essential point for your trading activities. You can set a detailed stop loss order or a general stop loss for all open orders when opening an account with all major brokers. In addition, you can get a mini terminal to boost your options for setting stop losses when opening a MT4-extended accounts. Even though you can read about how to choose the right stop loss, there are no a guiding principles for all traders or trades. For that, you will need to choose the appropriate stop loss limit. The following questions will help you to choose one:
What will the trade’s activity period be? Keep in mind that the longer a trade is open, the more volatile it will probably be.
- What is the target price and when do you expect to reach it?
- What is your account size and current balance?
- Do you have any open positions?
- Does your order size match your account size, account balance, period and current market situation?
- What is the general market sentiment (e.g. volatile, nervous, awaiting news or other external factors)?
- How long will this market stay open? (e.g. is the market closed overnight?)
You can learn how to set your stop mechanisms without taking risks by using our free demo account wherewith you will be able to set and test the stop mechanisms in different situations. In addition, you can also learn to read the indicative risk for stop losses in your account’s currency by using MT4 extensions (such as our trade terminal function), available in live accounts.
Forex and CFD Risk Management: Order Size
Do not worry if you cannot make profits on your first attempt, most traders, even experienced ones, do not make profit every time. Actually, the rate of profitable trades ranges between 5 and 8 out of 10. Therefore, the importance of making sure you have enough capital to outlast all of your market movements.
How to choose safe leverage?
At this point, you might know that if you choose too high leverage you will increase your risk of losses, but you also need to keep in mind that just a small number of negative trades can damage your overall trading results. To help you with this, you should:
- Choose your preferred Forex leverage.
- Do not trade with ridiculously high leverage, since it can result in significant losses.
External FX Risk Management Factors
You should always take into account how external factor can affect you when directing your Forex risk management strategies. Many factors that can influence your trading quotes, including:
- Power outages and/or problems with internet connection
- Being busy or focus on office work.
- Added value services.
FX Risk Management Additional Tool: SMS Notifications
Information is one of the keys to successful Forex trading. Some of the brokers do allow you to get free SMS-service It will enable you to receive quick information about processed deposits and withdrawals or impending margin calls.
The system is set to send you automated SMS notification when your margin level is at 130 percent, which will give you plenty of time to:
- Close Forex trades partially/fully
- Add money through fast-processing deposit options
- Take other actions.
- Negative balance protection policy
This is one of the most recommended tools in Risk Management for Forex and CFD trading practices.
Forex Risk Management in unexpected events
On January 15, 2015, the Swiss Central bank surprisingly untied Switzerland’s knots with the Euro. The nervous trades that follow caused a massive surplus in a part of the market and subsequently resulted in an intense deficiency of liquidity that made almost impossible to make trades through major market peaks. The amount of losses, rejections and negative account balances traders experienced due to this unexpected action were colossal.
This type of event it is called “Black Swan”. You still might be asking yourself, what does this means and how can I prevent it? Good Forex brokers take these things very seriously, therefore, they provide clear and open information that will effectively prepare to plan Forex trading risk strategies. However, it is impossible to be prepare for cases like Black Swan.
They learnt two things from the Swiss central bank case:
- Unpredictable events can cause game-changing variations.
- Central banks can also change their mind.
No matter what you do, you will never be fully prepare to face Black Swan events. Hence, the bottom line here is never trade money you cannot afford to lose. This tip will get you a long way in Forex and CFD leveraged trading.
FX Risk Management: Forex Regulations
The Financial Conduct Authority regulates most of the honest Forex brokers. Which, due to the copious security mechanisms it controls to ensure quality consumer services and maintains the integrity of the UK’s financial markets. It is considered a highly trustworthy organization. Deposit protection is one of the security mechanisms they regulate that guarantee your money will be secure, even in case of bankruptcy.
To avoid making the same mistakes over and over again, we advise you to periodically scrutinize your trading history and save it in a trade journal. This simple strategy will make you more aware of risks and your weaknesses. For instance, by doing this you might notice that:
- You are quite good at trading around news, or you have to familiarize more with a Forex risk management strategy that has led you to profits.
- You are getting negative outcomes for not knowing how to use a specific instrument, or you realize a particular Forex risk management strategy is connected to some concealed risks.
The learning possibilities are endless, but the point is constant – analyzing your past trades can positively influence future ones. Knowing your strengths and weaknesses is essential to successful trading.
You can benefit from keeping a trade journal in infinite ways. Just by tracking your footprints, you will learn which aspects of your trading skills are working and which are not and knowing this will significantly improve your game.
Forex and CFD Risk Management: Conclussion
Through the Forex and CFD trading market, you can make amazing profits daily long and short orders. However, do not forget that the potential profits are proportional to the risks, so you should really take the time to learn about effective trade and risk management. Once you start improving your trading skill your profits will significantly grow and, at the same time, your losses will decrease.
We understand that getting negative results from the start is quite rough for beginners, but, if this is your case, you have to overcome these results and acknowledge failure as a part of the growing process. Keep in mind that:
- You can’t always prevent losses
- You should be mentally prepare to face unexpected losses.
The information here provided seeks only to give a general idea of the trader’s risk management at the Forex and CFD trading risks. Since we do not provide investment consultancy, this article is not to be used as a guide, therefore:
- You should only use this basic information for your personal progress in risk management.
- We do not guarantee you will get better outcomes by following this information.
Nevertheless, you should not put Forex and CFD trading in a bad light! Remember, practice makes perfection. If you are constantly improving your skills and taking proper risk management actions, you will be positive trading in no time.