Strategies to Manage Investment Risk
When trading in Forex, risk management is a vital part of your overall strategy. If you were to attempt to invest without taking any precautionary measures, you would almost certainly find the end- result highly displeasing.
Many Forex traders make use of available leverage to extend their investment power, potentially providing them with big payouts for relatively moderate input. On the negative side, using leverage means that a sudden change in the market will also compound losses.
There are fallbacks available to Forex traders. For example, applying stop/loss to individual transactions, but there is no substitute for formulating an overall risk management strategy to minimise the impact on your portfolio as a whole.
In this guide, you will learn:
- Why risk management is very important
- What actually are risk management methods
- Some simple risk rules you can follow
What is Risk Management
There are some unique benefits when you trade in Forex, such as the availability of leverage to extend your investment margin. While this can significantly increase profitability, it can also increase your level of risk exposure and the possibility of a more significant loss.
A real-life example may put this into perspective:
You are out for a day at the races and decide that you can afford to gamble a maximum of $100. You know that you could potentially lose that money because horses can be unpredictable and volatile creatures.
A friend has given you a ‘red-hot’ tip for a specific horse and has offered you additional funding to place a much larger bet.
Will you place a moderate bet on that horse and several other bets on others? Or would you then borrow a further $1000 pounds and gamble all $1100 on that one horse, bearing in mind that there are five other races and a selection of 60 other horses?
With Forex, the potential loss risk is increased further by the cost of the trading fees and the spread, which your broker will collect regardless of whether there is a payout or a loss. If you read the statistics for Forex trading in percentage terms, you will see that there are more losses than gains for the majority of traders.
Employing a risk management strategy is all about limiting those losses and maximising chances of a payout. That is, to keep the total losses low enough for the overall payouts to exceed them in value.
Informed judgment is the key; investing what you can afford to lose and keeping leverage to a minimum. To help achieve this, wise Forex investors apply rules to their trades to avoid unanticipated losses.
Employing a risk management strategy is all about limiting those losses and maximising chances of a payout.
The One-Percent Rule
The one-percent rule is all about reducing the investment risk to a low proportion of your trading account as a whole. There are two different interpretations of the one-percent (1%) rule for Forex traders, the Equal Dollar Method and the Equal Risk Method. Within the Forex market, the methods generally used in different scenarios.
The Equal Dollar Method means never risking more than 1% of your total trading capital on one transaction. It is used primarily by traders who intend to maintain assets over a lengthier period.
The Equal Risk Method involves the addition of Stop/Loss to trades in such a way that potential losses are limited to only 1% of your portfolio capital.
Both versions of the one-percent rule are designed to reduce the risk of loss due to unforeseen factors, including broker Margin Calls or a full Stop Out. Both are equally valid and represent particularly useful methods of risk management for new investors to adopt while they are exploring the Forex market.
The 5/15 Rule
5/15 is described by some like a fraction ‘five fifteenths’ and by others as a ratio ‘five to fifteen’. Either way, the rule relates to the application of a solid ‘exposure management’ strategy: low multiple investment = lower risk per trade.
Here is a working example:
You start with $1000 which represents your entire portfolio.
NB. This amount is the actual capital in your account and does not include any available leverage.
You make your 1st trade @ 5% = $50
Your 2nd and 3rd trades are added concurrently both @ 5% = $100
Your Total Risk @ 15% = $150
By using multiple trades in this way, each trade risks a maximum of 5% of your portfolio as a whole, with an overall cap of 15%. This example is just intended to show a basic idea of one way to apply the 5/15 rule; there are certainly variations on this theme you may find worthy of more investigation.
The Diversifying/Hedge Rule
This rule harks back to a man named Harry Markowitz, an economist with a penchant for mathematical science. Markowitz was the originator of the MPT (Modern Portfolio Theory) which dates back to 1952.
The underlying concept, also known as the ‘Mean-Variance Model’ is based around a rather complicated mathematical equation. In simple terms, it is a way of measuring the expected returns (mean) and the standard deviation (variance) of different portfolios to select the most effective trades.
Theoretically, you can apply the rule to any number of simultaneous trades using a balanced mix of low and high risks:
Hedging – low risk = low gain
Loosely defined, hedging is a specific strategy where you are going against the expected result.
Speculation – high risk = high gain
Speculative trades are those made on unlikely, but not impossible, outcomes.
Diversifying means making a selection of opposing trades, which level out the overall risk to your portfolio. In the sense of Marowitz’s rule, the equation is then used to determine the ideal ratio of low and high-risk trades to achieve this.
Jessica has written for us for 5 years and offers a unique perspective due to her having worked in the financial industry internationally. In fact, Jessica has worked in a staggering 8 countries including Germany, China and the USA. Learn more.