Key Risk Management Principles in Forex Trading

Many novice forex traders begin trading without a trading plan, and this is one of the primary reasons why the vast majority of new traders lose money.

Even with a trading plan, if the plan lacks a good risk management component, regardless of how well the plan may work initially, a trader can eventually lose everything.

The sections below cover some of the primary risk management concepts that traders can consider incorporating into their trading plans.

Position Sizing
The first consideration for an effective risk management strategy involves what is known as "position sizing." As the name implies, position sizing consists of determining what size of position you are going to take on a particular trade when an opportunity presents itself.

Furthermore, position sizing can be performed in a number of ways that range from the simple to the decidedly complex. For example, some traders size trading positions by determining how much risk they are willing to take on any given position in relation to the total value of the portfolio.

Others might take a more simplistic approach and just trade a certain lot size. They might pursue this strategy until this set trading size clearly becomes too large or too small for their portfolio, which usually depends, at least in part, on their overall trading success.

Still other forex traders might size positions depending on how profitable they think a trade might potentially be. For instance, they might put on a larger trade than normal when they feel that the probability of success of that trade is higher than normal.

Alternatively, a trader might downsize a particular trading opportunity, or even eliminate it completely from consideration, if its risk to reward ratio is too unattractively high. Basically, they would be avoiding risking too much in order to make too little.

Limiting Losses
The second key risk management consideration has to do with managing trading risk once a position has been initiated. Most traders use stop loss orders placed immediately after initiating a position as an effective way of limiting risk that might arises from trading losses.

Some traders prefer to watch their positions instead of entering stop loss orders in order to avoid being whipsawed or having brokers shoot for and trigger their stops.

Nevertheless, this latter strategy can lead to a loss of discipline that can result in even worse losses than would otherwise have been seen. As a result, it would probably only be appropriate for more experienced and highly disciplined forex traders who are trading larger amounts.

Using Trailing Stops to Protect Profits
The third main risk management concept involves using trailing stop to protect profits as a position moves in the desired direction. Many traders make an initial move of their stop to breakeven once a hundred pips or so have been achieved.

Moving the stop even further toward the present spot rate will further protect gains once a trade becomes even more profitable. Doing so avoids having a winning position turn into a losing position.

In addition, trailing stops allow you to follow trends as they unfold for maximum profitability instead.