How to Using Proper Risk Management in Trading Forex

Posted 06/05/2009, 9:00 am EST by Sean Lydiard from tradingmarkets.com

The most common mistakes equity traders make when they begin to trade Forex are:

1. A failure to properly manage risk and

2. Not being aware of news events that will affect their Forex positions.

These mistakes are prevalent since there is such a huge difference in leverage between Equities and Forex. New Forex traders need to spend the time thinking about and understanding how leverage works, as well as how news and economic data will affect their trading plan.

New forex traders coming from an equities background, who are used to trading a cash account, understand that the profit and loss of their account is correlated on a 1 to 1 basis to the Value at Risk (VAR). In other words, a 10% rise or decline in the price of the stock will result in a 10% gain or loss on the cash position in their account.

Government regulations overseeing the equities markets allow traders to borrow up to 50% (2 to 1) of the purchase price of their securities for overnight positions and 4 to 1 intraday. A 10% move in a stock with 2 to 1 leverage will result in a 20% gain or loss on the cash on cash position in the account . A 10% move intraday with 4 to 1 leverage would result in a 40% change in the cash on cash value of the account.

Since a Forex account can be leveraged 100 to 1, a 1% move in a fully leveraged position would create a 100% gain or loss of the cash on cash value in your account. For each of the leverage changes in the previous examples the risk associated with the position changes dramatically. With the increased leverage of Forex trading, your trade plan must be adjusted to account for a shorter time frame in which to react to market news and or price changes. You cannot be trading Forex like a poker player and go "all in"; the increased margin creates too great a magnified movement in your profit and loss.

One solution offered by many Forex traders is to incorporate into their Forex trading plan the 2% rule. No more than 2% of the account value becomes the maximum amount the trader is willing to risk on a trade. This 2% becomes your "Value at Risk" VAR or (.02*Account Value=VAR). The VAR is then divided by the pip value to determine how many pips it takes to hit your max loss. The number of pips is deducted/added to the price bought or sold to determine placement of the stop loss.

For instance an account value of $10,000.00 would risk $200.00 on any one trade. A currency pair with a pip value of $10.00 would have the stop loss 20 pips away from the entry price. This is an easy tool that many use to help define risk within their accounts. Many experts have their own solutions' to position sizing. Author Van Tharp has written an entire book: "Definitive guide to position sizing" that outlines his premise on the absolute importance of not overdoing leverage and using position sizing to meet your objectives. It is his belief that this ONE tool is one of the most valuable, if not the most valuable tool to add to your trading system. You can read more about his solutions to position sizing at: http://www.iitm.com/Definitive-Guide-to-Position-Sizing.htm

While it cannot be overstated, the importance of position sizing to the potential success or lack of success to the Forex trader, it is just as important to be aware of news events affecting your positions. There is no excuse for being unaware of news given the availability of free information on the internet today. Equities traders have been lulled into complacency and are not obsessive about news because news events affecting stocks are often "pre-determined".

Pre-determined news releases are considered a controlled variable. One such example is a company's earnings announcements. Rarely do companies report earnings outside prescribed times and many websites provide earnings calendars. Typically earnings reports are released pre or post market so they do not disrupt the market and give investors ample time to digest the information.

On the other spectrum is currency trading that is affected by global economic news. This is new to most equities traders since foreign economic news is not something most equities traders follow. Since the currency markets never really close, economic news can be released anytime and move the market. A trader needs to be extremely aware of what events are forthcoming and what the data's effect will mean to their position. Following an economic news calendar is mandatory for the Forex trader. An excellent example of such a calendar can be found at www.mbtrading.com /economicCalendar.aspx. This calendar is free and is updated in a timely manner.

A Forex trader must familiarize oneself with an economic calendar and know when releases come out. Getting caught in a planned news event is an avoidable mistake. Simply checking an economic calendar and making sure to close positions ahead of news events can save your account from unnecessary losses. If you choose to hold a position through an economic news release your account should be lightly leveraged with a stop loss order in place.

To emphasize my point is this 5 minute chart showing the effects of a recent news event on 1/29/2009 and the 15 minutes following the U.S. Fed Funds announcement whereby they left rates unchanged:

EURO Chart

During my experience in the 30 year Treasury pit at the Chicago Board of Trade (CBOT), I became acutely aware of the effects of leverage and news. Working in the pits provided me a unique perspective to what is important to leveraged traders. It was critical to be aware of pending economic data and not get caught in a major spike one way or the other. In the pits most small traders would close any open position before the news announcement and the big players would lighten up their positions to manage their risk.

Seconds before the data would be released, you could hear a pin drop as the tension in the pits grew. When the data was released, wild fluctuations would take place in a matter of seconds, fortunes made and lost before the market digested the news and settled down. Since the release of news was such a dramatic event on the floor it taught me the importance of learning when news events would take place. Hopefully the hard fought lessons I learned in the pit can help others avoid these problems, though unfortunately, we often cannot learn the lessons of another.

Disclosure: Trading in securities, commodity futures and off-exchange foreign currency (forex) is speculative in nature and not appropriate for all investors. Investors should only use risk capital when trading securities, commodity futures and forex because there is always the risk of substantial loss.