What is Forex Risk Management? | How to Reduce Risk?

Risk management in trading comprises actions through which investors and traders discover, measure, analyze and mitigate risks when making trading decisions. Put simply, forex risk management refers to methods allowing forex traders to protect against the existing and possible risks in the foreign exchange market. The greater the risk, the higher the chance of substantial losses. So, established traders work towards the management of foreign exchange risk to minimize losses and maximize gains.

Why is Risk Management in Trading Important?

Every trader ultimately aims to scale their returns, but in a more thoughtful way so as to manage and minimise the risks involved. For instance, if your trade is not going the way you expected, it’s useful to learn to identify exactly what went wrong, what risk factors influenced the trade, and how you could have managed that risk more effectively. This will help you in your subsequent trades, enabling you to maximise the returns. 

Therefore, always assess and manage your currency risk and other risk types while holding a position, whether good or bad. A sound risk management strategy will play a pivotal role in driving the growth of your portfolio.

Risk Management

What are the Risks in Forex Trading?

Primarily, we can categorize risk into the following types:

(i) Aggregate Risk– Also referred to as ‘systematic risk’, ‘undiversifiable risk’, or simply ‘market risk’, it’s a risk that comes with the overall aggregate market returns, so diversification across a number of non-related currency pairs can’t help reduce this risk.

(ii) Specific Risk– The only way to protect your portfolio from a specific or ‘unsystematic risk’ is through diversification.

When trading in currencies, there are more specific types of foreign exchange risk you need to look out for:

Exchange Rate Risk

  •  Fluctuations in the currency exchange rate of closely linked countries can move the price of the primary currency by a significant margin. 
  • Political and economic events involving the Euro, for instance, impact the trading of the British pound sterling. Because of this, the GBP/USD might react in much the same way as the EUR/USD, even though both of these belong to different currency pairs. 
  • So, for your long-term success, it’s important to know what countries may affect the currency pairs you’re trading. 

Market Risk

  • The volatility or day-to-day fluctuations in the price of a currency pair is what defines market risk. However, volatility is necessary for market returns since investors can make money due to market movement. 

Country Risk

  • This type of risk applies not only to mutual funds, stocks, options, futures, and bonds but also to the currency issued in a specific country. 
  • Sometimes, a country may run the risk of not being able to get a grip on its financial decisions. This can have adverse effects on the performance of financial instruments in that country, alongside other countries that the defaulting country has links with. 
  • Countries having a severe deficit or emerging markets most often involve country risk. 

Economic or Political Risk

  • A common risk investors and traders face is that political or economic events in a country can drastically affect the prices of currencies related to that country. 
  • Even when a country is compelled to boost its exports by lowering currency prices, or faces too much government intervention in the markets, it amounts to a political or economic risk. 

Technology Risk

  • Many traders make the mistake of ignoring this risk, but in today’s world, where most individual forex traders conduct their trading and investments online, taking technology risk into account is a smart move. 
  • Make sure you have access to alternate Internet service and backup computers, just in case your primary system for your trading activities crashes or there’s any other sort of technology failure.

Interest Rate Risk

  • When a trade is open, interest rates may rise or decline. This affects the interest amount you might have to give each day until the trade closes. 
  • Technically, selling a currency with a high-interest rate implies that you’ll be charged interest per day at the time of rollover, depending on your broker’s interest or rollover policy. In short, interest rate risk is basically the profit and loss produced by forward amount and maturity mismatches in forex transactions, as well as fluctuations in the forward spreads
  • To predict any changes that may affect the outstanding gaps in foreign exchange transactions, constant analysis of the interest rate environment is essential.

How to Manage Foreign Exchange Risk?

When it comes to trading, the risk goes hand in hand with reward. The greater risk is most often associated with higher rewards, but this scenario depends on whether you make the right decisions. 

Let’s look at the strategies and theories investors and traders use for better forex risk management.

Understand the asset

  • Only when you understand the products you’re trading, particularly their features and complexities, can you precisely assess and measure the risk they present to your capital. If you jump into the fray without understanding your trade products, you will likely lose a significant amount of money. 

Find the right position size

  • You need to make up your mind about exactly how many lots you should take on a trade, i.e., the position size. On choosing the right position size, you can maximize opportunities, along with protecting your account. 
  • Evaluating your lot size and pip cost, determining your stop placement, and working out your risk percentage can help you select your position size. 
  • We know that preserving and growing your capital is the key to becoming a successful trader, and for that, you need to allocate your capital in a sensible manner. You may want to portion out less than two or three percent of your capital to a specific trade. 
  • Many traders and investors also place a limit on the number of open trades at a time. 

Identify the correlation

  • It’s impossible to forecast every risk you may face. But it’s not impossible to try minimizing or eliminating the risks that you can identify. New traders may have to face hidden risks, too, including correlation. 
  • In terms of trading, correlation is the mathematical connection between two or more financial instruments. For instance, if a change in the price of instrument B brings about a change in the price of instrument C in the same direction (like the price of instrument C rises due to a rise in the price of instrument B), the correlation between the instruments B and C is considered positive. 
  • On the other hand, the correlation will be negative if a change in the price of instrument B leads to a change in the price of instrument C in the opposite direction (say, the price of instrument B rises, while that of instrument C falls). However, if two or more financial instruments move independently, there is no correlation among them. 
  • This brings us to our third rule of risk management in trading: learn how different instruments are related before opening multiple positions in them. 

Tap on the power of stop-loss 

  • Disregarding stop-loss and sound money management practices is one of the biggest mistakes you can make. These are aimed at the preservation and growth of your capital. So, it’s advisable to always heed to and use the stop-loss feature. Such orders are placed for closing a trade as soon as a predefined price is reached. 
  • This way you can avoid potentially substantial losses if you already know the point at which you will exit a position. In short, you need to acknowledge when a trade is wrong, and allow a stop-loss to take effect or close the position altogether. 

Diversification

  • Regardless of whether your investments are currency-focused or not, an overall investment portfolio thrives on diversification. This opens the doors to multiple currency pairs and a slew of trading strategies you can use to equalize your market return on the whole. 
  • However, many people still believe that diversifying their portfolios will only dilute their trading profits. Diversification certainly doesn’t guarantee against a loss, but it is a great way to reduce your risk while you’re on your way to reach your long-term financial goals. 
  • To have a well-diversified portfolio, pick different currency pairs associated with different regions so that your unsystematic or specific risk is confined to a small region or group of countries. Also, choose different trade opportunities varying in time held and the risks associated. 

Want to learn more?

Now you know the basics of risk management in trading, the different types of risks involved in trading currencies, and how to manage foreign exchange risk. To learn about other aspects of forex trading, you can access more of our educational resources here.