Understanding Risk Appetite in Forex Trading

Understanding Risk Appetite in Forex Trading

Submitted by adil on Tue, 12/16/2014 - 14:01

When traders start trading in the forex market, the only goal they have in mind is to win huge profits. But this philosophy is not right in forex trading, especially if you want to trade in the market for a longer period of time. Forex trading is all about making the right moves at the right time. No matter how well you anticipate the market, it is likely that your anticipation is wrong due to the uncertainty that exists in the market.

A risk of loss is always there in the forex market, and in order to control that risk, it is important to realize that time and volatility are two key factors that shape the trading decisions. A trader should keep these factors in mind whenever they trade in the forex market. A successful trader always understands that nothing is guaranteed in trading, and therefore, always incorporate the forex risk management in their trading plan.

Following are some of the risk management strategies that are commonly used in the market:

Using the Stop Loss Strategy

Many forex traders forget that they cannot manage the risk without incorporating the stop loss strategy in their trading plan. Having a stop loss on the initial forex trade order is vital for the long term success of trading in the forex market. Being a forex trader, if you do not apply a stop on your trading position, you may probably end up suffering huge losses.

Not having a stop loss is like not having any money management in your trading plan, and it exposes you to 100 percent risk. Especially the new entrants need to incorporate it in their plan, or else they will be making the biggest mistake.

2% Rule for Forex Risk Management

The 2 % rule is one of the widely used risk management models in forex trading. The traders, who incorporate this model in their trading plan, calculate the size of their position with a stop loss size before executing the trade, and risk 2 percent of their available capital. The philosophy behind this risk management model is to minimize the losses when the market is down, and then slowly increasing the risk as the trading account of the trader grows.

When you suffer a loss, your trading account balance is negative, but once you keep 2% of your capital at risk, it eventually reduces the risk as compared to the initial trade. So, when the market is not favorable for you, 2% rule slows down the disintegration of capital value. However, you have to struggle a lot in order to recover the losses when you are using this strategy, because in a risk and reward system of money management where the targets are usually 3 times of what a trader earns, the return will not be as good as it could be before the losses.

Linear Risk Management

It is also known as the fixed-risk model, and a very simple and straight forward strategy for risk management in the forex trading. In this model, a trader chooses a fix amount of money that he can risk, and continue to risk the same amount every time he places a trade without considering whether his trading account is in profit or loss.

This approach is mostly used by the conventional traders, and is not suitable for everyone. However, if it is used in combination with the risk and reward 1:3 rule, traders will be in a better position to recover their losses smoothly without any getting into any complexity.

So, whatever money management strategy you use in the forex trading, make sure you are comfortable with the level of risk you undertake. If you have a trading plan and have made your strategies with probabilities, you are most likely to secure high returns in the long run.