Risk management: what it is and how to use it

Risk management, also known as money management, refers to a number of trading techniques employed to lessen risk exposure. Being affected by various factors, currency rates may be quite volatile at times; thus, protecting your account against adverse price fluctuations is an essential part of a trading strategy.

What is risk management?

Risk management is like having a safety plan to preserve capital in case the trade does not play out. Traders use various strategies and technical analysis tools to protect their money and any profits they might make. Since currency prices can change unexpectedly, having a good risk management plan helps them avoid losing much money.

The core concept of money management is to avoid risking more than 1–2% of personal funds on any single trade. This principle may significantly reduce risk exposure: provided that only 1% of the initial deposit is at risk, even after several losing trades, you are likely to retain the majority of the account balance. Let's elaborate on this further with an example.

Suppose you have a trading strategy that is 90% successful. In a sample of 100 trades, if one is risking 10% per trade, there is a possibility one might have a run of 5 losses. This would translate to a 50% loss of capital. Therefore, it is necessary to have a solid risk management strategy in Forex. Trading Forex without risk management is simply gambling.

Risk Reward Ratio (RRR)

Risk Reward Ratio denotes the potential profit in comparison to the amount you may lose for any given trade. For example, when you risk 100 USD in a position to potentially gain 300 USD, the risk-to-reward ratio is 1:3.

A ratio of 1:2 is considered the minimum one should aim for, as only a third of positions would need to be profitable to remain break-even.

As shown above, the take-profit level marked 2 should be twice as high as the stop-loss level marked 1. Stop-loss and take-profit orders close the position when the price reaches the predefined level a trader sets. This way, stop-loss and take-profit levels can define potential profit and loss.

Why risk management is important

Here is why risk management is the core element of trading:

Risk management process

Here are the steps to take to manage risks while trading.

• Decide how much you can afford to lose. Before entering a trade, decide how much you're willing to lose in case the market turns against you. A common guideline is to risk no more than 1–2% of your total capital per trade. For example, with €5,000, the maximum risk per trade should be around €50–€100, and no more than €150 at the high end.
• Set a stop loss. A stop-loss is a tool that automatically closes a trade if the price moves against you by a certain amount. This helps limit how much money you can lose on a trade. For example, if you buy EURUSD at 1.19500 and set a stop loss at 1.19300, the trade will automatically close if the price drops to 1.19300. That way, you limit your loss to a small amount instead of letting the loss grow larger. It's a simple but powerful way to protect your money.
• Figure out your trade size. Position sizing means deciding how large a trade to take based on your account size and risk. Getting this right is crucial for protecting your capital and managing risk properly.

To calculate position size, traders usually consider:

• Account size – the total amount of money in the trading account
• Risk tolerance – the percentage of the account you're willing to risk on one trade (typically 1–2%)
• Stop loss distance – how far the stop loss is from your entry price, in price units (pips)
• Currency pair volatility – some pairs, like gold or GBPJPY, may move more than others, affecting how much you might lose
• Exchange rate and pip value – used to convert price movement into actual monetary value.

Position sizing is calculated using the following formula:

• Think about your risk/reward ratio. This means comparing how much you stand to gain versus how much you could lose on a trade. A common guideline is to aim for a reward that's at least twice the risk. For example, if your stop loss is 20 pips, set your take profit target at 40 pips. It's like risking $1 to try and make $2—a setup that gives you better odds of long-term success, even if not every trade wins.

Advantages and disadvantages of risk management in trading

Here are the positive aspects of using risk management in your trades:

• Protects your capital

Risk management limits how much can be lost on any single trade, helping preserve your account over time.

• Reduces emotional trading

With clear limits in place, it's easier to stay calm and avoid impulsive decisions during market volatility.

• Enables long-term growth

Surviving losses without wiping out your account allows you to keep trading, learning, and compounding profits.

• Supports consistent decision-making

A solid risk plan keeps your strategy grounded in logic, not emotion or guesswork.

Here are the challenges of RM in trading:

• Missed opportunities

Being overly cautious can sometimes mean exiting trades too early or missing out on bigger gains, especially with tight stop-losses.

• Steep learning curve

For beginners, understanding and applying risk management tools can be complex. It takes time, study, and practice to do it well.

• Time and attention required

Effective risk management often means monitoring trades, adjusting strategies, and staying updated with market changes.

• False sense of security

Having a risk plan doesn't eliminate all risks. Markets are unpredictable, and losses can still happen even with strong risk controls in place.

• Added costs

Some risk management tools, like hedging or trade insurance, come with fees that can reduce overall profit margins.

How to use risk management in trading

Here are the key strategies you can apply in Forex trading to protect your money and succeed long-term.

Stop-loss orders

Use a stop loss. The stop loss is a predetermined price at which the trade closes to limit further losses. For example, if you buy a currency at a specific price and set a stop loss at a lower price, it helps limit your losses. If you buy EURUSD at 1.19500 and set your stop-loss order at 1.1930, you're risking 20 pips (a tiny measure of price change).

Position sizing

Position sizing means calculating the lot size one should take. Forex traders consider these factors to calculate position size. The example below shows how to calculate position size.

1. Account size $10,000
2. Risk percentage 2%
3. Stop loss used—25 pips
4. Pip value depends on different pairs. For example, for a standard lot of EURUSD, the pip value is about $10 per pip, while for EURGBP it may differ due to exchange rates and can be roughly $13 per pip.

Below, we calculate the position size (Lot Size)

EURUSD example:

EURGBP example:

Hedging

Hedging is like having a backup plan to protect your trades. If there's a risk the price might drop, you can hedge in two main ways: holding opposite positions or using options.

Holding opposite positions means buying and selling the same currency pair at the same time. If one position loses value, the other can help offset those losses. Using options works like insurance for your trade.

For example, if you expect a currency's price to rise but worry it might fall due to upcoming news, you can buy an option that gives you the right to sell it at a set price later. This protects you if the price drops.

Leverage

Leverage lets you control a lot more money than you actually have. It's like borrowing money to make more significant trades. While it can increase your profits, it can also increase your losses. So, it's important to use leverage carefully. Think of it like driving a fast car. It's exciting, but you need to be responsible to avoid accidents.

Examples

Let's say you open 1 lot EURUSD Buy order at 1.12097. To achieve a risk-to-reward ratio of 1:2, you can set the stop-loss level at 1.12077 (2 pips) and take the profit level at 1.12137 (4 pips). Thus, you will only be risking 20 USD to gain 40 USD. Depending on your initial deposit, you can set SL/TP levels even further as long as your risk is below 1–2% of your personal funds.

1. Potential loss 20 USD
2. Potential profit 40 USD
a. risk
b. reward

It is important to note that the price of each pip depends on the trading tool and the volume of your position. You can find the pip price per 1 lot on the Spreads and Conditions page or simply calculate it using a trading calculator.

A trailing stop can be used to adjust the stop-loss level automatically whenever the price moves in a favourable direction. This reduces the risks and may eventually lock in the profit already gained.

Keep in mind, however, that neither stopping loss nor taking profit is guaranteed: when the market is volatile or during a price gap, your order may be executed at a price different than expected.

You can learn more about events and indicators that affect market volatility in this article.

Final thoughts

• Risk management in trading is crucial because it helps you keep your money safe and make more intelligent choices.
• It helps to determine how much risk you can handle by considering your financial goals and the level of loss you're comfortable with.
• Feelings like fear or greed can lead to bad choices, so staying calm helps you stick to your plan and manage risks better.
• Some good ways to manage risk include learning about the market, practising on a demo account, setting limits on how much you're willing to lose, using stop loss and take profit, spreading out your risk instead of putting all your money on one trade, and being careful with borrowed money (leverage).
• Even with a solid plan, remember that trading always has some risks, so it's essential to be prepared for ups and downs.