Understanding your risk tolerance
Dear Traders,
It's important to measure and manage the risk exposure of a currency pair's exchange rate.
Why specifically?
Because it reduces your account vulnerabilities to major fluctuations, which could adversely affect profit margins and your account.
Simple right?
A common definition of exchange rate risk, relates to the effect of unexpected exchange rate changes on the value of the currency pair or the currency alone.
Not understanding your risk tolerance, will negatively affect your account - it's just a matter of when.
The main Forex risks
During Forex trading you will encounter three types of risks:, including:
- economic
- transactional
- operational.
Knowing how to deal with these risks, will help you survive in Forex and CFD trading.
Economic risk
Economic risk, reflects the risk to the currency exchange rate (caused by various economic factors).
Global news and data releases, affect the Forex markets in different ways.
Here's a quick heads-up:
...if you don't follow the economic calendar…
...you are not prepared.
There is no issue finding this information - there are numerous news and data reports, across multiple channels to choose from daily.
But understanding which report you need to see, is not so simple.
Check-out the following video for tips on how to deal with various data releases.
You should also read about fundamental events generally, to better understand how they can affect your Forex and CFD trading.
Transactional risk
Transactional risk incorporates leverage, stop-loss, correct strategy and general market volatility factors.
It's critical to successful trading because correct use of leverage and stop-loss, for example, will ultimately determine your trading profit.
Analysing the price and having a good strategy is not enough, if you trade with huge risk margins.
Remember:
...if you cross 5% of your risk threshold…
...then you are technically trading high risk.
The goal is to find the optimal balance between leverage and risk.
I suggest never trading with more than 5 % of overall risk, per day.
Operational risk
Operational risk involves technical and broker's risk.
Your equipment has to be fit for purpose.
For example, your:
- platform must function correctly, whenever you are trading
- computer should be strong enough not to freeze and lag
- internet should be working fast and properly
- backups should be maintained in case of a black out.
And if you want to monitor and manage your trade progress on the move, it's good to have MT4 Android, iPad or Iphone at your disposal.
When it comes to Forex brokers' having operational risks - none of them are exempt.
But brokers normally have well established internal procedures, organizational structure, technology and liquidity processes to ensure business continuity.
Your broker should always ensure your maximum client protection and comfort during trading.
Understanding risk tolerance
"Trading using leverage carries a high degree of risk to your capital and it is possible to lose more than your initial investment. Only speculate with money you can afford to lose."
This is crucial to understand.
High leverage usually equals high risk, because you can theoretically lose more than the money you deposited in your account.
Don't forget that you are still liable if a problem occurs during the liquidation process or if your account goes into debt, hence the high risk of losing more than what you put into the account.
So a broker offering negative balance protection, is a real bonus.
But bear in mind:
...there's nothing wrong with leverage, if you manage risk correctly and use it wisely.
The biggest problem when there is volatility and emotions start to affect you, is errors that will quickly escalate to magnified losses.
Determining your risk tolerance involves several different things.
First, you need to know:
- how much money you have to invest
- your investment and financial goals.
For instance, if you plan to retire in ten years and have not saved towards it then you will need to:
- have a high risk tolerance, because
- you will need to do some aggressive (i.e. risky) investing, to reach your financial goal.
On the other hand, if you are young and just starting to invest for retirement - your risk tolerance will be low.
What about day and swing trading
When you start trading, you will be asked to choose a package from various core options including:
- account type
- desired leverage
- available currencies to deposit your account with.
The various account types brokers offer, can be confusing at first:
...but be sure to check all the available account types, because…
...each account comes with specific terms that will shape your strategies later.
If you have a good understanding of leverage and trading generally, a standard account should suit you.
If you're a complete beginner, you should:
- first practise on a demo account, then
- open a mini account, and
- generally start trading conservatively.
I personally use different accounts with different strategies and I can afford to trade with margin if I am about to build-up a small account.
However, I am more conservative with my larger accounts.
Grow your account organically
...begin with small sums and low leverage each day or week…
...while adding to your account as it generates profits.
Compounding is an excellent way to exponentially boost your profits, if you are able to consistently follow it.
Remember - a larger account does not necessarily mean greater profits.
If you can increase the size of your account through trading, great.
If not, there's no point burning cash in the Forex furnace.
Start low and end high
To limit the risk on every trade you make, your:
- trades should start with between 0.2% and 1% of your account balance
- overall risk exposure should be maximum 3% per day.
You should base your risk on your own performance, but as noted earlier - it is better to start your day with less risk.
This way you can make more trades while remaining under the risk limit and eventually end your day (or week) in a profit.
Cheers and safe trading,
Nenad
