| Forex risk management involves a combination of | | | | Risk/reward ratio: |
| responsible use of leverage, appropriate lot size, | | | | A trade's risk/reward ratio determines whether you |
| correct placement of a stop loss order and a | | | | should take a trade or wait for the next trading |
| profitable risk/reward ratio. When used correctly, all | | | | opportunity. The bare minimum risk/reward ratio is |
| of these ingredients are combined into a recipe that | | | | 1:2. In other words if the risk is 20 pips then the |
| does not risk more than 1-2% of your trading | | | | reward should be 40 pips. A risk/reward ratio of 1:3 |
| account for any single trade. | | | | would be a risk of 20 pips and a reward of 60 pips. |
| Leverage: | | | | Proper risk/reward ratio will allow you to be wrong |
| Leverage allows you to use a small amount of capital | | | | 50% of the time and still be profitable. |
| in your trading account to control large amounts of | | | | Let's look at an example trade using EUR/USD that |
| capital in your trades. If a forex broker offered a | | | | follows sound risk management. We have determined |
| leverage of 200:1, it would only take a deposit of $50 | | | | that the overall trend is up so we are looking to go |
| to control a $10,000 trade. Likewise if a broker | | | | long (buy). We determine we want to buy at 1.3500. |
| offered a leverage of 400:1, the same $50 deposit | | | | The last low point was at an area of support at |
| could control a $20,000 trade. | | | | 1.3480 which is 20 pips lower. We can see that the |
| Forex leverage can be a double edged sword - it can | | | | next area of resistance is 40 pips higher at 1.3540 |
| work for you by amplifying your wins, or against you | | | | which will serve as our target. |
| compounding your losses. Just because a broker | | | | We have a micro account balance of $10,000 and we |
| offers high leverages of 200:1 or 400:1 doesn't mean | | | | are using 50:1 leverage which would allow for a trade |
| that you should use it all the time. When you are | | | | of 5 regular lots or a position size of $500,000. |
| new to trading, a leverage of 20:1 or 50:1 is much | | | | However, we want to use sound risk management |
| better than a higher leverage. | | | | so we only want to risk 2% of our trading account |
| Lot size: | | | | for this trade - 2% of $10,000 is $100. With a stop |
| Lot sizes determine the dollar value of each pip. Micro | | | | loss of 20 pips that would mean we could trade a |
| accounts offer $1000 ($0.10 per pip), mini accounts | | | | position of $5000 - $5 per pip x 20 pips stop = $100. |
| offer $10,000 ($1 per pip) and regular accounts offer | | | | We place a limit order to trigger at our target of |
| $100,000 ($10 per pip) lot sizes. These pip values are | | | | 1.3540 which is 40 pips. 40 pips x $5 per pip = $200 |
| based on trading EUR/USD. | | | | or a risk/reward ratio of $100/$200 or 1:2. |
| Stop loss: | | | | Trading forex carries with it a high level of risk - but |
| Think of a stop loss order as trading insurance. Just | | | | it doesn't have to be "risky" as long as you use solid |
| as you wouldn't drive without auto insurance - you | | | | forex risk management. Make protecting your |
| shouldn't trade without a stop loss as insurance | | | | account balance a priority over making a profit and |
| against excessive losses. Correct stop loss placement | | | | you will find your account balance steadily increasing |
| is based on the trade entry, areas of support and | | | | even with a number of losses. |
| resistance and risk/reward ratio. | | | | |