With its high liquidity and other benefits, trading in the Forex market can be exciting because of the high potential for profit-making available to traders. However, the lucrative nature of the market also makes it risky and highly volatile as a trader can find themselves having to endure losses that they may not recover from.
A lot of traders, especially first-time traders who do not fully understand the high volatility of the market end up losing their investments and may remain scarred by their experience. What differentiates successful long-term traders from the rest is their ability to sustain profitability by assessing the risk, using tools, and creating strategies to manage the risks.
While there are several risk assessment tools, some are a cut above the rest as they are proven to help assess and manage risk more effectively.
What is Risk Assessment in Forex Trading?
Risk assessment involves identifying and analyzing potential risk factors that can negatively impact your trades. It is a way of evaluating the degree of loss that may be suffered if an action is taken and how to take action against it.
Knowing how to assess risks in forex is one of the most important skills a trader must learn as it allows them to reduce their losses by coming up with effective strategies and discarding the ones that do not work. In forex trading, you should always think about protecting what you have first by reducing exposure to risk before considering what can be made from trading and this is why risk assessment and management is an important part of any successful trading strategy.
Best Risk Assessment Tools for Trading
This is also called trading on margin. It involves using borrowed money to increase a trader’s trading position. It is a common practice in forex trading as it helps to increase the rate of returns if done correctly but it amplifies losses as well.
The amount of leverage a trader is granted is determined by a broker and it can go as high as agreed between the parties; however, most brokers tend to give first-time traders lower leverage because of the risk involved.
Since the amount of leverage used is based on the degree of risk a trader is willing to take, most professionals tend to keep their leverage low at first since it gives them a chance to access the risks and keep their profits consistent.
2. Value at Risk Calculator
The Value at Risk calculator is a tool used to determine the risk inherent in a trade. It estimates the extent of possible losses that can happen over a fixed period.
Having a value at risk calculator to assess risk is important as it considers the volatility of the forex market and gives you a glimpse of the worst-case scenario in a trade. To calculate value at risk, the amount of loss, the possibility of the loss occurring, and the timeframe are put into consideration to give you accurate results.
3. Stop Loss Limits
Stop-loss limits or stop-loss orders are used by traders to reduce the risks and protect the profits already made on a trade. This is usually an order sent by traders to brokers or platforms where their trades are made soon after a trade is initiated. Once the pre-set price threshold is met, the order whether to buy or sell is triggered.
Stop-loss limit is an important tool for traders as they don’t need to monitor the daily performance of a currency pair after the price threshold has been set but the downside is, the order can easily be activated by short-term fluctuations which can affect the trader’s ability to make profits or make them open to loss. It is also a good way to determine the level of risk you are comfortable with.
When using a stop-loss order, place it at a level where your existing profits from trade are protected if the market goes down but there is still enough room to make a profit. The position of the stop-loss order must be based on the current market conditions and your trading signal.
4. Risk-Reward Ratio
The risk-reward ratio in forex is a tool that traders use in calculating how much risk they are taking compared to the reward for such risk. In order words, it shows a reader what they stand to gain for every dollar they risk in trade i.e. the expected returns.
Traders use this metric to assess the risk involved in trades and decide on which trades would be most profitable based on the degree of risk that comes with it. Plus, with derivatives like put options and stop-loss orders, traders can manage their risk-reward easily.
Calculating your risk-reward ratio is done by dividing the risk by the reward. A trader can determine their risk through an established stop-loss order while the reward can be determined by the profit target set by the trader when a currency is sold.
Although using this ratio will be profitable in the long run, it needs to be paired with other metrics or tools like the payout rate for you to get more accurate information.
5. Position Size Calculator
For day traders, position size may be more important than entry and exit points because it determines how much risk they are taking on which can negatively or positively impact their trading account.
You can calculate your ideal position size manually by considering several factors:
- Account balance
- How much of your account balance you are willing to risk
- Stop loss in pips
- Your current currency pair
- The exchange rates of your currency pair
As a trader, you can easily calculate your position size with this formula: $ at Risk / (Pip Risk x Pip Value) = Position size. Alternatively, there are position size calculators that you can find useful.
6. Custom Alerts
Another useful tool for assessing risk is custom alerts. Most trading platforms allow traders to customize their notifications if their position is threatened. These alerts help forex traders to easily identify potential risks or changes and determine how to deal with them; however, it is important to exercise caution and be logical while assessing the risks of changes.
Tips for Risk Assessment and Management in Forex
While these tools can help you access and manage risk better, having a strategy or rules that you follow can ensure that you properly implement these tools for the best results. To assess the risks in the forex market, you should:
Understand the level of risk you are willing to take
Before any trader can identify risks affecting their trades, they must define their risk appetite. This will prevent them from reacting abruptly due to market fluctuations as they have already determined their level of exposure and the best strategy to protect their profits from unforeseen risks.
Carry out technical analysis regularly
To make informed decisions, you need to ensure that you are not led by sentiment, especially in the forex market where there is high volatility. Traders are expected to gather and track data regarding their trades with the help of risk indicators and tools that can provide a complete idea of the amount of risk their portfolio faces and which areas would be most affected.
Always remember that you are going to face a degree of risk with every trade
Although the goal of every trader is to make more successful trades than losses, it is important to remember that risk is an inherent part of the forex market and losses are sometimes inevitable no matter how diligent you are. What is important, is that you remain aware of the risk and use the information gathered to create strategies that would reduce your current and future exposure to it.
Practice with a demo account
Demo accounts are good for both beginners and experts who want to test their skills before trading with real money. If you are not sure of your ability to use these risk assessment tools effectively, start with a demo account and gradually build up your skill before trading with a real account.
Be up to date with relevant news and events
The purpose of risk assessment is to identify potential issues before they have an impact on your trades and one of the best ways to do that is to be aware of the factors that cause the market to fluctuate. You can then use this information to come up with strategies that will protect your profits and increase your ability to make successful trades.
A forex trader needs the right set of tools in their arsenal to make a profit and it is important that you include them in your trading strategy or plan and make a habit of using them to identify risks when entering a trade and coming up with measures to guard against huge losses.