With higher than normal volatility in most financial markets at the moment, it’s worth reviewing your risk controls and money management. Here are 7 easy tips that will help to lower risk when trading foreign exchange and any other market.
1. Keep your leverage low
Leverage is a powerful tool in investment. Like most things, if misused it can get you into trouble. While leverage will multiply gains, it will also multiply losses. The higher leverage is, the less room there is for mistakes.
The amount of leverage sets the position sizes that you can control. A leverage ratio of 100:1 means that for every $100 of your own money you can control a position of up to 100 times that size – that’s $10,000.
This allows you to create much greater returns on your investment than if you had put all of the money up front yourself.
Put another way, this is like buying a $100,000 house with a $1000 deposit. The deposit is your equity. If the price of the house rises just one percent to $101,000 you’ll double your equity. But a one percent fall in price would take your equity down to zero.
2. Set correct stop losses and take profits
Setting the correct stop loss and take profit is one of the most important decisions in the entire trade setup. But too often, the stop loss/take profit is set arbitrarily. It might be set at a fixed size for every trade to cap the loss at a certain amount. Or worse the stop loss might be decided simply by the amount of money in the account in an ‘all or nothing’ gamble.
The decision on where the trade will exit (either at profit or loss) should factor-in the state of the market and the length of time the trader is prepared to wait for a profit. Setting correct stops/take profits will lower risk and lead to better and more consistent trade outcomes. See here. When a trader guesses these limits they’re already losing control from the outset.
3. Trade higher timeframes
Trading shorter time frames is more stressful, time consuming and in most occasions, less profitable. The minute charts (1 minute to 30 minute) are more volatile and unpredictable in relative terms. High frequency trading also incurs more trading fees because the ratio of spreads to profits is correspondingly much higher than for strategies that hold positions for longer duration. Slippages will also be proportionately greater.
The longer time frames, such as the hourly chart, 4 hourly or even the daily chart can provide more certainty on which to plan trades. Fees and slippage are also proportionately lower.
4. Look for a reason not to trade
Most of those involved with trading get a daily bombardment of messages telling of events in the financial markets. The charts seem to be screaming “buy” or “sell”. Everyone out there seems to be making money!
When a trader has money sitting idle in their account, it can be tempting for them to place orders. At least then there’ll be some action!
Remember that brokers and news provider don’t care if the markets go up or down. It’s not their money at risk.
Thinking clearly and objectively amid all of this hype is one of the biggest challenges facing a trader. Always look for a reason not to trade. Ask, what if? What if that next economic announcement misses expectations? What if that technical setup doesn’t pan out? What if that latest hot stock/forex tip is wrong? Plan for the least expected.
There’s a well-proven link between over trading, and underperformance that we should all take note of. Resisting the temptation to trade on emotions avoids unnecessary risk and unproductive use of capital.
5. Avoid trading around big economic announcements
Hardly a day goes by without some economic announcement or other. But the biggest ones need to be treated with caution. Surprise announcements from central banks such as unexpected changes in interest rate policy can send the markets into a tailspin. Jobs reports, inflation figures, and consumer spending data can also have a high impact across many markets.
Keep a check on the economic calendars. For day trading it’s fairly easy to plan trades around these events. Traders holding positions for longer can use hedging to soften the blow of any potentially big movements or consider closing them if necessary.
6. Trade markets with low correlation
Setting limits on the amount to risk on each trade position is a good practice. But if the holdings in a trader’s account all move in the same way this won’t give them any real protection. Many currency pairs have high correlations – as much as 80% to 90%. This means when one trends in a certain direction the other is likely to as well. So holding a basket of correlated currencies will concentrate risk rather than diversify and lower risk.
When trading pairs with high correlation it is worth checking to see if the same end can be reached by trading fewer pairs with lower correlations. This could help to reduce trading fees as well.
Correlations aren’t fixed but are changing all of the time. Use this simple hedging indicator to check across different markets.
7. Set realistic goals
Monetary returns in any kind of trading activity can be unpredictable from month to month. But having a firm goal in mind does help to focus. The goal for many traders is simply to earn as much money as possible, as quickly as possible. But this won’t necessarily keep them on course or provide them with a realistic scale of progress.
It’s better to set a firm goal, such as a return on initial investment then use that as a yardstick to measure headway.
Setting a goal too high can cause excessive risk taking. When a trader underperforms, they’re more prone to take bigger and bigger risks to reach their objective.
The returns of professional traders offer a useful benchmark. A BIS study which tracked performance over a number of years found that the average return among strategies used by professional currency traders was around 3.5% per year before leverage. Of course these are just averages. Some strategies made much more and some much less.
When learning, the goal can be as simple as aiming to break even over the month. Then increase as progress is made.