The forex market is very liquid and provides a rich backdrop to speculate on price movements, also known as forex trading. When you trade, you want to ensure that you can enter and exit a trade with minimal movements. The forex markets move in tiny increments called pips. The volatility in the forex markets is generally at levels where brokers are comfortable providing clients with leverage, allowing them to use borrowed capital to magnify their trading power (as well as risk). Many brokers also offer negative balance protection to help you avoid losing money beyond the equity you hold in your account.
Risk Management Using a Stop Loss
The movements of currency pairs constantly fluctuate, providing an opportunity for traders to capture directional changes by opening and closing either short or long deals. When the exchange rate of a currency pair causes a loss, you need to be prepared to exit your position. One of the most efficient techniques you can use to avoid significant losses is a stop-loss order. This technique allows you to determine in advance how much you are willing to lose. You can either place a stop-loss order with your broker or watch the market consistently and exit when the exchange rate reaches that level.
The benefit of putting in a stop-loss order with your broker is that if the exchange rate moves to that level when you are not watching the market, you will still get executed on your order. You can place a stop-loss order where you want to exit and a stop loss limit order which is the maximum loss you are willing to assume once a currency pair triggers your stop-loss order.
How Much Does a Market Move?
Your risk management using a stop loss order will play a significant role in determining your trading outcome. The forex markets move in tiny increments called pips (price interest points), which allow you to enter and exit a trade at a set price. If the market is moving very quickly, after an economic release or a monetary policy decision, you might experience slippage when you exit your trade. Slippage is the amount that a market will move once you place a trade, primarily if large transactions coincide. For example, if you place a stop loss on the EUR/USD at 1.2020 and filled on your trade at 1.2015, you would have experienced 5 pips of slippage.
Leverage Cuts Both Ways
These small price movements can have a significant impact on your trading if you plan to use leverage. Leverage is the use of borrowed capital to enhance your gains. Unfortunately, leverage cuts both ways. Not only can you experience a magnified trading power when you use leverage to trade, but you can also experience a significant loss.
For example, if you place a $1,000 EUR/USD currency trade and it moves in your favor by 1%, you will gain $10. If you use the leverage of 100 to 1, you can gain as much as $1,000. This scenario means that a 1% move using 100:1 leverage could double your returns. This situation also means that if you lose 1% while using the leverage of 100:1, you will wipe out all the capital you put into your trade.
Negative Balance Protection
While using leverage, you can get yourself in a situation where the equity in your account can be wiped out if a market moves quickly. If you only have $1,000 in your account, you will lose your entire equity in the example above. One of the ways that your broker can assist and help you avoid losing more than the equity you have in your account is to provide you with negative balance protection. Negative balance protection is a forced liquidation of your assets to cover any losses before the equity in your account declines below zero. This feature generally will come after a margin call. A margin call is when your broker alerts you that the current equity in your account is at a level where they need you to post additional equity or liquidate another position. A negative balance protection option can be advantageous if you are not around and cannot adhere to the margin call.
The Bottom Line
The upshot is that there are several ways to manage your risk when forex trading. A stop loss is a critical risk management method that allows you to exit with a predetermined failure. Additionally, you can further manage a stop loss using a stop loss limit order which caps your maximum loss on your stop-loss order. Most brokers will also provide you with leverage that will allow you to increase your trading power, however leverage cuts both ways, and higher trading capital comes in conjunction with the greater risk of loss. Your broker will also assist with risk management in providing negative balance protection, which will eliminate the likelihood of the equity in your account dropping below zero.