How To Figure Out Your Risk Tolerance
The forex market is an active and liquid market, with the potential to bring excellent rewards for traders. Over $6.6 trillion of trade volume is achieved per day, so there is no shortage of opportunities to make substantial profits. However, this flexibility also comes with a certain amount of risk, which needs to be understood.
When it comes to successful trading, establishing your risk tolerance is one of the key strategies. Here’s a look at what risk tolerance means in relation to forex trading, and how to determine what your personal risk tolerance is. A well thought out strategy will make you more confident and capable of balancing risk and reward in your trading.
What does risk tolerance mean in forex trading?
Risk tolerance in trading means the degree of variability that you can stand financially in your investment returns. In other words, you need to ask yourself what is the maximum amount of money you are willing and able to lose in each deal? This will be an individual choice, depending on your personal circumstances.
What’s your level of trading experience?
If you’re reading this, it’s likely that you are new or just making your first forays into forex trading. Therefore, it makes sense not to throw yourself in at the deep end. Start off small, with a low-risk program, or even a demo account, and find your feet.
Most newbies tend not to risk more than 1% or 2% of their total capital per trade until they have more experience under their belt. This means that if you were to start with $10,000 in your account for example, and were to set a maximum loss allowable of 1%, you would never end up losing more than $100 per trade.
There will be plenty of time for the more strategic manoeuvres further down the line, so you don’t need to take any serious risks at this point. Remember that profits tend to come to those who manage risk carefully. Study the strategies and psychology of forex trading to help sharpen up your skills, and you’ll soon be ready for the big time.
How much capital do you have to play with?
To take any managed risk with your investment, you need to ask yourself how much disposable income you have to play with. That is, what percentage of your earnings or savings are available to you, after your bills, mortgage, taxes, and all your other outgoings have been paid out.
To test this out, ask yourself what percentage you are happy to risk, and comfortably go about the rest of the day without monitoring the situation like a hawk. It is likely to be an amount which won’t threaten your ability to pay for essentials such as food, housing, and energy, or eat too drastically into your holiday fund.
Find out the amount you’re willing to lose, based on an honest and realistic assessment of your financial circumstances, and don’t go beyond that. It can be tempting to push yourself over your limits, because greater risks reap greater rewards in forex trading, but this is a dangerous path to tread if you are going to end up with unpayable debts.
Be consistent with your risks
It can be easy to be lured into a false sense of confidence with the first flush of success, and increase your positions, or take larger positions, but this is a classic rookie error. Take the attitude that a loss may be just around the corner, and don’t let a run of profits alter your risk management strategy.
Remember that the forex markets are extremely dynamic, and the wheel will soon turn, whatever the current situation may suggest. Therefore, becoming overambitious too soon in your trading career is never a good idea. Be strong, and maintain a consistent approach if you want to see the best results.
Keep up with your positions
Check up with your positions at the end of each day. Depending on what platform or app you are using, this may be automatically displayed for you. It will let you know if there are pending positions, and how much available cash you have.
Learn to read the market
Make sure that you are familiar with forex trading terminology, and keep on top of the forex news. This means you will be able to anticipate how the market will behave. The demand for currencies is influenced by geopolitical events, tourism activity, the economic buoyancy of a particular country, interest rates, and many other factors.
The forex markets fluctuate on a daily basis, and obviously, a weaker currency means there is always a stronger currency to profit from somewhere. Currencies are traded in pairs, for example, the EUR/USD (Euro/US Dollar) and the USD/GBP (the US dollar and the British pound).
Currency pairs that are not associated with the USD are known as crosses, or minor currencies. The currency pairs of emerging markets are known as exotic pairs. New traders will not usually invest in emerging markets, as although they often experience fast growth, they can be unstable, and less well-regulated than advanced economies.
Pay attention to commodity prices, as the strength of a currency is linked to the major commodity exports of a particular currency. For example, the New Zealand Dollar (NZD) is strongly linked to the price of wool and dairy products. When the demand for these products rises, the cost will rise and the currency will strengthen.
The Canadian Dollar (CAD) is heavily correlated to the volume of oil exports for that country, and the Australian Dollar (AUD) is linked to the price of gold and iron ore. A ‘Bear Market’ is a term used to describe a market where all currencies are on a downward trend, usually as a reaction to disruptive geopolitical or environmental events.
A Bull Market on the other hand is when events take a more positive turn, and as a result economic confidence rises, leading to an upward trend in currency prices.
Learn about the psychology of trading
Of course, you need to know the technical nuts and bolts of forex trading to be successful. However, it is just as important to be aware of the psychological investment you are making. You will need to be able to make good decisions in a short timeframe, and manage your emotions.
Good traders look beyond their gut reactions, in order to remain objective, and gain a competitive edge over their rivals. Making quick decisions and thinking on your feet can lead to subjective responses, so you need to fine tune your thinking and overcome this natural human tendency.
Dealing with profit and loss margins naturally creates a fear of losing, and a greed for greater profits. However, being in thrall to these two emotions can lead to serious mistakes. Swift reversals in market trends can catch out those who try and push profits to a maximum, while the overly cautious will struggle to make progress.
This is where your risk management strategy can help you out. As we have discussed already, you need to know what your risk tolerance is from the outset. This will act as a built-in check and balance system, and prevent you from losing unmanageable amounts of money. A new trader might set a limit of 1%, for example.
Broaden your knowledge base
As we have also discussed earlier, you can gain more insight and expertise into forex trading by researching and studying the markets. This will lend a greater depth and foresight to your decisions, allowing you to see beyond temporary glitches and spikes, and develop an eye for the bigger picture.
Therefore, keep up to date with the financial press, including trade journals, and speak to people who work in the sector if you can. Forex trading is strongly driven by macroeconomics, which means the economy as a whole, rather than individual behaviour. Current affairs, such as political decisions, can influence the economic health of a country.
The forex market depends on the balance of trade between nations. If a certain commodity is in high demand, then this will strengthen the currency of the country which produces it. This is because foreign buyers must convert their currency into that of the country they wish to purchase the goods from.
Develop an understanding of the factors that drive economic growth and decline around the world, in order to keep up with the complexities of forex trading.
Accepting risk
Finally, it is important to accept that risk is all part of trading, and that losses are not failures; even the most experienced of traders sometimes make losses. However, by careful risk management, you can learn how to stack the odds in your favour, and minimise your level of risk.
Financial trading without a risk management strategy removes any control from the situation, and is basically the equivalent of gambling. By learning how to gauge your personal risk tolerance, you will increase your skills as a trader, and also prevent yourself from ending up in a precarious financial position.
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