Taking your first step into the world of Forex trading can be daunting.
Type “Forex Education” into Google and you will be inundated with so many different strategies, patterns and setups that it can be difficult to know where to start. While these things are important parts of your Forex learning curve there is one topic that should, but in the case of most beginner traders won’t, be at the top of the list; risk management.
It is in our nature to focus on the positive side of a new endeavor, and to start out on a journey by first considering what you stand to lose can be counter intuitive, but risk management is the cornerstone of any Forex strategy and nothing can help you get under way more effectively than a sound grasp of its principles.
Forex Risk Parameters
The good news is that it is a relatively simple concept. Before you enter any Forex trade you can, and should, decide at what level you will exit, whichever way price moves. These levels are called risk parameters. If price moves against you, you will exit at a predetermined level using a stop loss. If it moves in your favor, you will exit at your predetermined profit target.
Forex risk management suggests that you should never risk more on a trade than you stand to gain. In other words, the gap between your entry and stop loss should always be smaller than the gap between your entry and profit target. The difference in size between the two is called a risk reward ratio.
Different Forex Traders Use Different Ratios
There is a difference in opinion between traders as to what risk reward ratio is optimal. Some Forex traders will only enter trades where they stand to gain three times risk (a 1:3 ratio), others are happy to take trades where the potential reward is one and a half times risk (a 1:1.5 ratio). A generally accepted standard however, is that beginner traders should only look for setups that offer a minimum 1:2 ratio.
No trader is right in the market all of the time; very few are right 75% of the time. As a beginner trader it is realistic to expect to be right, at most, 50% of the time. By only entering trades with a 1:2 risk reward ratio you only have to be right more than 30% of the time to profit in the long run. Trading Forex in this way can help ensure that you stay in the market long enough to get a feel for whether your strategy is effective, and to build upon it if it isn’t.
All said, while it is important to know what sort of price action constitutes a setup, and which setups are the most effective under certain market conditions, none of these things matter if you don’t have any capital in your account to take advantage of them. The only way you can learn to trade Forex is by trading.
To trade you must be solvent, and to stay solvent you must master, and stick to, the principles of risk management.
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