It might sound obvious, but the first rule in currency trading, or any other kind of trading for that matter, is to only risk the money you can afford to lose. Many traders, especially beginners, skip this rule because they assume that it would not happen to them.
If trading were like casino, you wouldn’t take all the money you have to the casino to bet on black, right? Well, it’s the same with trading — don’t take unnecessary risks by using money you need to live.
Why?
Because it’s possible to lose all your trading capital, and secondly, because trading with funds you live on will add extra pressure and emotional stress to your trading, compromising your decision making abilities and increasing the chances of making mistakes.
The Foreign Exchange market is a very volatile and unpredictable market, so it’s better to trade from your disposable income.
Before you start trading, you need to determine your risk tolerance, depending on:
Knowing your risk tolerance is not just about helping you sleep better at night, or stress less about currency fluctuations.
It’s about knowing you are in control of the situation, because you’re investing the right amount of money in relation to your financial objectives.
Keep your investing within your risk tolerance and you will decrease your income.
Knowing about risk/reward ratio (RRR) will definitely improve your chances of becoming profitable in the long run, setting limit orders (stop-loss and take-profit) that protect your capital.
A RRR measures and compares the distance between your entry point and your stop-loss and take-profit orders.
For example:
Let’s say that you’re investing on the EUR/USD.
If the distance between your entry level and your stop-loss is 50 pips, and the distance between your entry point and your take-profit is 150 pips, then you would be using a RRR of 1:3, because you’re risking 50 pips to earn 150 pips (150/50 = 3).
The risk/reward ratio is a necessary tool to set your stop-loss and take-profit orders depending on your risk tolerance, and every wise trader should control the downside risk.
Even though determining a RRR depends on each trader’s risk tolerance, it’s common to use a risk/reward ratio of 1:3, where you expect to earn 3 times what you’re willing to lose.
When thinking about risks, you also need to consider your trading capital.
You should only invest a small portion of your trading capital per trade: a good starting point would be to not invest more than 2% of your available capital per trade.
If you have $10,000 in your Forex trading account, the maximum loss allowable would be $200 per trade.
Determining the risk per trade is a helpful tool if you go through a losing streak, so then you can better protect your trading capital, and avoid large drawdowns in your trading account.
Most beginners will increase the size of their positions as soon as they’re making profits, which is one of the best ways to get your account wiped out. Keep your risk consistent.
Just because you’ve made a few winning trades doesn’t mean the next one is going to be profitable.
Do not become over-confident and less risk-averse, as that will lead to you changing your money and risk management rules without solid reasons.
When you worked on your trading plan, you had to set up rules to decide about an effective size for your positions. This is just one step in establishing a successful trading method, now you need to stick to and follow your trading plan!
The three margin products we’ve introduced so far in the guide – spot Forex, CFDs and spread bets – are all leveraged products.
Leverage means that you can trade more money than your initial deposit, thanks to margin trading. Your broker will only ask you to put aside a small portion of the total value of the position you want to open as collateral.
When using leverage, your profits can be magnified quickly, but remember the same applies to your losses in equal measure. This is why you need to understand how leverage and margin trading work, as well as how they impact your overall performance and trading.
Forex traders are often tempted to use high leverage to make significant profits, but if you’re over-leveraged one quick change in the market, or a simple mistake, could end up with an outsized hit.
In August 2018, the European Securities and Markets Authority (ESMA) imposed limitations on the leverage offered by brokers. These leverage limits on the opening positions by retail traders vary depending on the underlying:
- > 30:1 for major currency pairs, and
- > 20:1 for non-major currency pairs.
ESMA did this for a reason: retail traders, especially new ones, are normally bad at managing leverage and end up losing money because of it.
Because currencies are priced in pairs, it’s important to understand that currencies are linked to each other, or correlated.
Knowing about Forex correlations will help you better control your Forex portfolio’s exposure by reducing the overall risks. Correlation represents a measure of how one asset’s price changes in relation to another.
If two assets are positively correlated, it means that they tend to move in the same direction, while if they are negatively correlated, they will evolve in opposite directions.
To use FX correlations to your advantage, you need to remember a few things:
For instance, if you go long on the EUR/USD and the USD/CHF, you can expect both currency pairs to evolve in opposite directions, which is almost like having no trading position in your account.
Why?
Because the USD is used once as a base currency (USD/CHF), and once as the quote currency (EUR/USD), which means that if the USD strengthens against its major counterparts, then the EUR/USD will go down, while the USD/CHD will go up – the evolution of one exchange rate cancelling out the other one.
For instance, if you go long on the EUR/USD, the AUD/USD, and the GBP/USD, you can expect these currency pairs to be positively correlated because they all have the same quote currency, the USD.
It means that when the USD strengthens/weakens, your portfolio will go up/down.
Commodity currencies represent currencies that move in accordance with commodity prices, because the countries they represent are heavily-dependant on the export of these commodities.
As a general rule, if the price of commodities strengthen, then the currencies of the commodity producers will go up — and vice-versa.
The main correlations to know about are the Canadian Dollar (CAD) and oil, the Australian Dollar (AUD) and gold/iron core, as well as the New-Zealand Dollar (NZD) and wool and dairy products.
To improve your Forex trading performance, you should understand your exposure: some currency pairs move together, while others evolve in opposite directions. The key is to diversify your portfolio to mitigate risks.