The risks associated with doing business all need to be properly managed. Businesses are all open to risks from movement in the competition’s pricing, the cost of raw materials, the competitor’s cost of capital, foreign exchange rates, and interest rates- it’s vital that you know how to manage these risks properly in order to make educated moves, instead of merely taking a gamble.
Using risk management guidelines will help you understand some of the good practices in exposure management. The guidelines must be understood and internalized so you can custom tailor a plan for your company that will show to have positive benefits over time.
Understanding Forex Risk Management
Trading is the exchange of goods or services between two or more parties. So if you need gasoline for your car, then you would trade your dollars for gasoline. In the old days, and still in some societies, trading was done by barter, where one commodity was swapped for another. A trade may have gone like this: Person A will fix Person B’s broken window in exchange for a basket of apples from Person B’s tree. This is a practical, easy to manage, day-to-day example of making a trade, with relatively easy management of risk. In order to lessen the risk, Person A might ask Person B to show his apples, to make sure they are good to eat, before fixing the window. This is how trading has been for millennia: a practical, thoughtful human process.
This is Now
Now enter the world wide web and all of a sudden risk can become completely out of control, in part due to the speed at which a transaction can take place. In fact, the speed of the transaction, the instant gratification and the adrenalin rush of making a profit in less than 60 seconds can often trigger a gambling instinct, to which many traders may succumb. Hence, they might turn to online trading as a form of gambling rather than approaching trading as a professional business that requires proper speculative habits.
Speculating as a trader is not gambling. The difference between gambling and speculating is risk management. In other words, with speculating, you have some kind of control over your risk, whereas with gambling you don’t. Even a card game such as Poker can be played with either the mindset of a gambler or with the mindset of a speculator, usually with totally different outcomes.
There are three basic ways to take a bet: Martingale, anti-Martingale or speculative. Speculation comes from the Latin word “speculari,” meaning to spy out or look forward.
In a Martingale strategy, you would double-up your bet each time you lose, and hope that eventually the losing streak will end and you will make a favorable bet, thereby recovering all your losses and even making a small profit.
Using an anti-Martingale strategy, you would halve your bets each time you lost, but would double your bets each time you won. This theory assumes that you can capitalize on a winning streak and profit accordingly. Clearly, for online traders, this is the better of the two strategies to adopt. It is always less risky to take your losses quickly and add or increase your trade size when you are winning.
However, no trade should be taken without first stacking the odds in your favor, and if this is not clearly possible then no trade should be taken at all. (For more on the Martingale method, read FX Trading The Martingale Way.)
Know the Odds
So, the first rule in risk management is to calculate the odds of your trade being successful. To do that, you need to grasp both fundamental and technical analysis. You will need to understand the dynamics of the market in which you are trading, and also know where the likely psychological price trigger points are, which a price chart can help you decide.
Once a decision is made to take the trade then the next most important factor is in how you control or manage the risk. Remember, if you can measure the risk, you can, for the most part, manage it.
In stacking the odds in your favor, it is important to draw a line in the sand, which will be your cut out point if the market trades to that level. The difference between this cut-out point and where you enter the market is your risk. Psychologically, you must accept this risk upfront before you even take the trade. If you can accept the potential loss, and you are OK with it, then you can consider the trade further. If the loss will be too much for you to bear, then you must not take the trade or else you will be severely stressed and unable to be objective as your trade proceeds.
4 ways to help minimize your trading risk
• 1. Choose your trade sizes carefully
Some traders have a tendency to get caught up in quick price movements and open positions without thinking about sensible entry and exit points, stop loss positions and so on. This means they will often end up supporting positions too large for their accounts. Instead, you should always trade with a strategy based on thorough market analysis. Never let the adrenaline and potential for profit rule your head.
• 2. Limit your losses
Another effective way to minimize your potential downsides is to employ stop-loss orders on every trade. Stop-losses automatically exit a position when a trade reaches a certain price point, therefore limiting losses or locking in profits depending on the point at which they are applied.
For example, imagine the euro is about to rise against the U.S. dollar, and that you have opened a position of 100,000 units at $1.4500. Placing a stop-loss order at $1.4460 would limit your maximum loss to $400 while also giving the trade room to potentially turn around should the market start to move against you.
• 3. Analyze the markets and the activity around them
As Sandy Jadeja, Technical Strategist of FX Solutions, states: “The methods of utilizing technical analysis are many and varied. They include such ubiquitous concepts as head and shoulders, support and resistance, trends, moving averages, and double-tops.”
Fundamental analysis also brings a host of potential catalysts into consideration in the form of major economic reports and news events. Analyze both past technical data and news feeds to gain a clearer picture of the state of a currency.
• 4. Spread your trades
Though you should only trade currencies you know, many traders find it safer to speculate on a number of different pairs than to put all their eggs in one basket. Understanding a range of currencies can help to diversify your risk and increase your knowledge of the activity beyond your trades. Remember though, diversification does not assure a profit nor guarantee against loss.
Start by choosing the size of your trade with careful consideration. Traders can have the tendency to get swept up in quick price movements and opening positions without considering good entry and exit points, and stop loss positions- doing this will usually mean that the moves end up supporting positioning that too large for their accounts. Trading with strategy based on market analysis is the smarter move.
Using stop loss orders will help to minimize your possible downsides. These stop losses act automatically top employ an exit position when trades reach a particular price point- this will limit losses and lock in profits.
Analyzing the markets, including the activity around the, will bring a host of potential considerations into the picture. Using both past technical data and news feeds to gain a clear picture of the state of currency will minimize bad moves.
Spreading out your trades will prevent the old ‘too many eggs in one basket’ mistake. Although, you should only trade through the currencies you know- but you should understand a vast range of currencies in order to diversify your risk and increase your knowledge of activity going on outside of the trades you are making. Diversification does not, however, assure a profit or minimize loss, but does help traders to understand other trades outside of their own.
Do you have a system to minimize your risk when making trades for your company? Let us know what works for you.