Understanding Leverage and Risk Management in Forex
The Forex market presents many opportunities for traders to make money. Traders, however, need to adopt a risk management strategy to be successful in the long term and to avoid any mistakes. In Forex, making money means that you want your profits to be greater than any potential losses. This is only possible if you are aware of your own limitations and if you know how to manage and control the risk that you take. Examples of risk management techniques include using a “stop loss” order, hedging, using leverage properly, trading during specific hours and defining the right entry and exit points. Let’s review some of the most important risk management techniques in more detail.
When we speak about the risks associated with Forex trading, the first thing to mention is leverage. The simple explanation of leverage is that it allows you to place larger trades with less money. For example, if you’re using 1:500 leverage, with only $200 you can place an order worth $100,000. This way you can significantly increase your profits if the market goes in your direction, but you should also consider that your losses are also amplified if it doesn’t. Therefore you should consider carefully the leverage you want to use when trading. At LiteForex the minimum leverage you can choose is 1:1, and the maximum is up to 1000:1 depending on the type of live account you have opened.
In order to minimize losses, it is recommended that Forex traders use stop orders in their strategies. This order type is also known as “stop loss” and is used to automatically close an open position in case the market is moving against you, thus limiting further losses. For example, if you have placed a long position, the stop order price should be set below the current price. On the other hand, if you’ve placed a short position, then the stop order price is placed below the current market price. Many traders use stop orders because they can calculate upfront the loss level they are willing to take for each trade. Also when using a stop order you don’t have to monitor your open positions constantly. Even if you are not in front of your computer, the stop order will be automatically placed when the set price is reached.
Define the right entry and exit points for you
Apart from the tools that are available in the trading terminal, losses can be minimized when you follow a strict plan and know exactly when to cut a potential loss on a particular trade. Discipline is crucial for this approach because once you have decided where to stop the loss, there must be no hesitation. You can determine your risk/reward ratio by calculating the number of pips that are likely to be gained in a trade opposed to the number of pips that you risk losing if the trade is not successful. By defining this ratio in advance, you are able to select the best places where to enter and exit the trade. As a rule of thumb, the ratio must be positive with some of the Forex gurus suggesting at least 1:2 risk/reward ratio. For example, you would not like to risk more than 100 pips in order to make a potential profit of 200 pips. The winning percentage of one trade has to compensate for two losing trades.
Do not take more risk than you can afford
Risk management also includes protecting your capital, and not taking risks that you cannot afford. It is no surprise that one of the most popular rules recommends not risking more than 5% of your capital on a single trade. You never know if your next trade will be a winning or losing one, and if it turns out to be a losing trade, you will still have 95% of your capital left over to make other trades. Adopting a more conservative investing approach will help you preserve your money and give you more chances for profit in the long run.
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