What Is FOREX Risk Management?
Trading the foreign currency exchange (Forex) markets is risky. The inherent volatility can cause an investor to lose his capital rather quickly. Price movements in Forex trading is measured in percentage in point, or PIPs. The smallest value of a PIP is 1/100th of 1 percent, or one basis point (0.0001). On a wrong trade, these small price movements can wipe out your account. Therefore, having a sound risk management strategy is extremely important.
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Leverage
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It is common to trade Forex on margin, which is the equity you must maintain in your account as collateral to hold a certain position. Most Forex brokers allow you to leverage your account by 50 to 100 times your capital. For example, $100 in capital in an account with 50 time leverage gives you buying power of $5,000. Trading on margin is a double-edged sword. It can greatly enhance your profits but also amplify losses if you are wrong on a trade. If the loss reduces your collateral below the minimum threshold, expect to receive a "margin call" by the Forex broker asking to replenish the funds in the account. The broker can liquidate the account for failing to maintain adequate capital.
Risk Management
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Given the potential for loss, preservation of capital is of paramount importance. The main risk management tool employed by traders is a stop-loss. This is the maximum allowable loss a trader is willing to risk on a trade. Thus, on any given trade, a Forex investor can place a limit order with his broker that includes a stop loss. A limit order gives the broker a specific price to execute the trade. By using limit orders, setting a price target and using a stop-loss, the Forex trader controls his risk to return ratio.
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Example
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The quote for euros is EUR/USD 1.4515/19. A trader who expects the euro to appreciate sets a price target of 1.4919. He can enter a trade to purchase 100,000 euros for $145,190. Assuming a 2 percent margin account, the trader needs $2,904 to take the position. He places a stop-loss at 1.4419. If the euro appreciates to 1.4914/1.4919, he realizes a profit of $4,000 (($1.4919 - $1.4519) x 100,000 euros). However, if the euro depreciated instead, the trader's stop-loss could be executed at 1.4419/1.4423, for a loss of $1,000. The return-to-risk ratio for this trade was 4-to-1. The loss reduces the trader's capital position by $1,000.
Trailing Stop
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Using the previous example, the trader can execute the trade with a trailing stop. A trailing stop adjust upward or downward according to the position that this taken on a trade. For example, if the trader could have place his buy order for EUR/USD at 1.4519 with a trailing stop of 50 PIPs. If the euro appreciates to 1.4715, the trailing stop moves up to 1.4665. This means if the euro retraces and falls to 1.4664, the trader is stopped out at 1.4665, but makes a gain of $1,460 (1.4665 - 1.4519) x 100,000 euros.
Hedging
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Another risk management tool employed by Forex investors is called hedging. In hedging, a Forex investor can a place trade that he believes will protect his gains by investing in another currency pair such as the USD/JPY or in the derivatives market. The hedge acts as an insurance policy and counterbalance on his original trade. Using the previous example, the trader may sell Japanese yen expecting it to decline versus U.S. dollar. If he is right, the profit he makes on the hedge trade will mitigate or offset the loss on the EUR/USD trade.
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