Forex Risk Management

However — and this is important — forex risk management is more difficult to achieve than in any other tradable. If the trend is your friend, then the stop-loss is your bosom buddy and will keep your head above water and prevent you from drowning. In this situation, drowning means losing so much on a trade that there's insufficient capital left to trade again. There may be some money still there, but not enough for margin and investment.

STOP-LOSSES AND FOREX
If your experience is primarily with stock trading, you may be using a 7% stop-loss (considered a prudent strategy) with every stock you buy. But there is no single stop-loss strategy that works with every currency trade. In forex trading, your stop will be dictated by the size of your capital, the reward/risk you hope to achieve, and the time frame you are trading. One of the many online tutorials I've studied stated that in FX trading there are two time frames: three days or less, and more than three days.

Let's analyze these situations by discussing the mini account, assuming you want to get started with a minimum cash outlay.

The mini account has a 200:1 leverage, which means that the minimum trade (one lot = $50) controls $10,000. Further assume you are trading a currency pair where the US dollar is the second currency, and one pip = $1. You open an account with the minimum $300. How does the size of the account dictate the stop-loss?

Here's a real situation. One of the stop-loss strategies that has been around for ages is setting a stop at 2% of the investment: 2% of $50 is $1 = one pip. My trading program (and most others) will not allow stops and limits tighter than seven pips, so a fixed percentage is out, unless you want to let the program's limitations set your stop. Set the stop at seven pips, which is 14% of the investment. If you're comfortable with that, fine. But how does that tie in with the reward/risk you want to maintain?

Say you have determined from a 30-day daily chart that the pair you're interested in has an average daily range of 100 pips. You could set a profit target of 100 pips. But that would mean getting in at the very top of the top or the bottom of the bottom. That's not very likely! So at the time you want to enter the trade, say the price has bounced off support and is up 20 pips. You could set a reasonable target of 80 pips before hitting resistance. If you wanted to maintain a 2:1 risk/reward ratio, you would set your stop-loss at 40 pips below your entry price. You are risking $40 to make $80.

So far, so good. But suppose you want to go one step further and trade four lots to make the investment worthwhile. The trade goes against you and you are stopped out. You have lost $160, which is more than half your capital. If you were trading two currency pairs with the same result, you would be getting a margin call.

NOW WHAT?
It's obvious you have to rethink what you can do with a $300 account. Putting aside the idea of increasing the amount of capital, the only option is to work within your budget, which may mean waiting till the moneys you wish to allocate to forex trading reaches an amount where you can afford the risk. Once you reach that stage, you should start by planning on only one lot in one pair initially. Build up your capital until you can afford to take on more risk. One lot is $50 of margin.

A word of caution here: This is not like buying stock or options, where the most you can lose is $50. You are trading on margin (borrowing from the broker or bank). Without a protective stop, you could end up in serious debt! It is similar to selling a naked call without a stop-loss. You could decide that the most you want to lose is $25, which would mean you set your stop 25 pips below your entry. But how does this relate to the risk/reward you want to achieve? Are you risking $25 to make $20? You can't set a stop mechanically without considering the entire trade and evaluating the profit potential.

So remember, risk varies inversely with knowledge and experience. To reduce your risk, you have to increase your knowledge of the foreign securities market and your experience in trading in it. You have to learn which economic indicators influence the direction of the various currencies and which do not. Currencies are much more volatile in short periods than the security market (in general). If you set the stop too tight, you could get stopped out on a whipsaw, and then watch the price soar on a recovery.

Here's where experience counts. Start with a demo (paper trading) account. Experiment with indicators you like, and the many different time frames you can monitor. A one-minute chart will not give you the same picture of the trend the way a one-hour or daily chart will. Consider all of the caveats, develop a risk management strategy, and test it. Set a profit goal, say a 25% increase in your initial capital, and when you've hit it, go a step further and trade real money. It's an exciting and rewarding experience. Go for it!

Rudy Teseo is a private investor and currency trader who has taught classes in option trading and technical analysis.

SUGGESTED READING
Teseo, Rudy [2005]. "Forex, Anyone?" Technical Analysis of Stocks & Commodities, Volume 23: July.