Chapter 18

Ten Rules of Risk Management

In This Chapter

Limiting the financial downside

Getting a handle on human nature

Managing your market exposure

When people think about risk management in the context of currency trading, the natural tendency is to zero in on the risk of losing money. No two ways about it, that’s the ultimate risk. But traders can head down many different streets before they get to their final realized profit or loss address.

Throughout this book, we stress that risk management is a multifaceted process that ends only with the final trading tally. In case you skipped it, check out Chapter 13 for more detailed ideas on the various forms of risk. Sometimes, what you don’t know can hurt you.

How you navigate the avenues of risk has as much to with trading outcomes as it does with whether you ever reach the final destination. In this chapter, we group ten practical rules of risk management to guide you in your forex trading.

Trade with Stop-Loss Orders

Stop-loss orders are the ultimate risk-limiting tools. (The exception is data/events where stop-loss order executions may be subject to substantial slippage. Avoid that risk by not carrying positions into news releases.) If you trade without stop-loss orders, you’re exposed to virtually unlimited risk. Always have a stop-loss order in place for every open position, and don’t move the stop-loss order except to protect profits. Do your analysis and risk calculations before you enter the trade, and then stick to your trading plan.

Leverage to a Minimum

Position size will ultimately determine how much financial risk you’re exposed to — the larger the position, the greater the risk. Don’t be seduced by high leverage ratios and take too large a position. Trading too large a position relative to your available margin reduces your cushion against routine, adverse price movements. Keep your use of leverage to the minimum needed to trade your strategy.

You can request a lower leverage ratio from most forex brokerages to systemically limit your leverage utilization. Just because they offer 50:1 or 100:1 leverage doesn’t mean you have to use it all.

Trade with a Plan

The best way to limit the inevitable emotional reactions that come with trading is to develop a complete trading plan from entry to exit (stop loss and take profit) before you ever open a position. (We devote most of Part III to the merits of trading with a plan.) Committing yourself to having a trade plan for every strategy will also keep you from speculating on a whim or overtrading (always having an open position). Of course, no trading plan will work if you don’t follow it, which brings us back to the human risks in trading. You stand a much better chance of sticking to a trading plan if you’ve drawn one up in the first place.

Stay on Top of the Market

Make sure you have a firm grasp of what’s happening in the market and the currency pair you’re trading. Know what data and events are scheduled in the days and weeks ahead. Consider liquidity conditions during your trade plan’s time horizon. What has the market priced in and priced out? Anticipating market events and conditions won’t guarantee a winning trade, but it will alert you to potentially disruptive circumstances that you can factor into your trading plan to limit overall risk.

Trade with an Edge

The currency market trades around the clock, but that doesn’t mean you have to be in it all the time. Pick your spots, and choose your timing; don’t get pulled in by the noise. Keep your ammunition dry, and look for trade setups with a clearly defined risk/reward scenario. Be opportunistic, and spend your time and efforts looking for trading opportunities still to come instead of getting caught up in the market move of the moment. Other opportunities will surely develop, and you’ll be ready for them.

Step Back from the Market

When you’re not involved in the market, a funny thing happens: Your perspective is clearer; your objectivity is at its peak; you’re not emotionally invested in a market position. Make it a point to square up and step back from the market on a regular basis. Use the downtime to catch up on your charting and fundamental analysis. Take time off completely, and just forget about the markets for a while. When you return, you’ll be refreshed and thinking more clearly, ready for new trading opportunities.

Take Profit Regularly

Taking profit regularly is the surest way to limit risk. By definition, if you take profit — even partial profit — you’re reducing your exposure to market risk. Your trade plan may have a more aggressive profit target, but if market events play out in your favor, it pays to protect what you’ve gained by taking partial profit or adjusting your stop-loss orders to lock in some of the gains. It may be a fluke that the market jumped 40 pips in your favor on a data release, or it may be a fluke that the market dropped back by 50 pips ten minutes later. The only way to be sure is to take some profit. You can’t go broke taking profit.

Understand Currency-Pair Selection

Market risk varies significantly from one currency pair to the next, based on volatility, liquidity, data sensitivity, and many other factors. Each currency pair brings its own idiosyncrasies to the table, requiring different analytical tools or strategic approaches. Different currency pairs also carry higher or lower margin utilizations and pip values. Make sure that you understand what currency pair you’re trading and that your trading plan reflects that pair’s characteristics. (Chapters 8 and 9 look at the trading behavior and drivers of the most heavily traded currency pairs and crosses. Not all currency pairs are the same.)

Double-Check for Accuracy

Currency trading is a fast-paced environment made even faster by electronic trading. The risk of human error in inputting trades and orders is ever present and requires diligence on your part to avoid costly errors. A stop-loss order won’t help if it’s entered for the wrong currency pair or the wrong amount. Make it part of your routine to double-check every trade and order entry you make, ideally before you submit it but at least immediately after you make it. Mistakes happen to everyone, but only careless traders let minor errors slip through and become big disasters.

Take Money out of Your Trading Account

Here’s one you won’t see in many trading books: If you’ve made some money in the market, make periodic withdrawals from your trading account. We call it taking money off the table. If your profit stays in your margin account, it’s subject to future trading decisions, which represents an unknown risk. Keep your margin balance at a level that allows you to trade in sizes you’re comfortable with. Also, remember why you’re trading — it’s not just about the money, but what you can do with it. Withdraw your profits, and spend or invest them the way you always said you would.