Forex Risk Management Basics

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You can have the best forex trading system in the world, but without a solid forex risk management plan in place, you could lose everything. Just what is risk management? Simply put: it's a collection of ideas offering downside protection to investors. This can include limiting your trade lot size, ​hedging, trading only during certain hours or days, and recognizing when to take losses.

Unfortunately, many traders fail to implement these measures. Why? Mainly because they enjoy pursuing big bucks by making risky investments using leverage--despite the high chance of suddenly losing everything. And while many traders have had success practicing these trades with demo accounts, they're overconfident and unable to succeed when it comes to executing such moves for real. But responsible traders take precautions.

Controlling Losses

Knowing when to cut your losses on trades is a powerful risk control method. This can be done with a "hard stop", where you use trading platform technology to lock in a stop loss at a certain level, or this can be done with a "mental stop", where you psychologically decide to limit the drawdown you're willing to take on a trade--essentially making a promise to yourself to jump ship at a certain point. With either method, it's crucial to resist the urge to move your stop loss farther and farther out, as investment values decline.

Using Correct Lot Sizes

Broker advertisements make it seem feasible to open an account with $300 and use 200:1 leverage to facilitate mini lot trades of 10,000 dollars, then doubling your money in a single trade. But this is highly risky and ill-advised. When it comes to initially determining your lot size, it's best for new investors to start small, to allow for greater flexibility in managing trades.

Tracking Overall Exposure

While using a reduced lot size is a good thing, opening multiple lots with currency pairs could cripple you. For example: if you go short on EUR/USD and long on USD/CHF, you are essentially exposed two times to the USD. And if the USD tumbles, you'll suffer a double dose of pain. But keeping your overall exposure limited can reduce your risk and increase your prospect for long-term success.

The Bottom Line

Limiting risk ensures that you'll be able to stay in the game and continue trading--even when things don't go as planned.