Psychology & risk management for forex traders – an in-depth overview

Risk is inevitable, however, some behavioral adjustments or having a plan to mitigate the risk may help reduce or control its impact if it happens.

Trading in the financial markets, especially the currency market, presents exposure to different types of risk. Risk events can impact the forex exchange rates in different ways. They can lead to wild fluctuations, start or reverse a trend, or, although uncommon, be an uncontrollable market shock that may lead to a trade halt.

This means that traders always need to take risk management into account when trading. Some traders make the mistake of focusing too much on their strategy and may overlook the risks involved. Their strategy can be successful; however, not having enough risk management tools in place can lead to ruin.

Generally speaking, risk can be divided into three types: market or trading risks, trader or self risk, and money management risk. They all complement each other and should be considered collectively and implemented individually when trading FX or any market in general, regardless of the strategy used. We will go over some examples of risk and provide an understanding of different types of risk, as well as examples that can help traders set up their risk management methodologies. We must also remember that the risk remains, even if we have risk management strategies in place; our goal is to reduce or mitigate the risks.

The term market risk covers a variety of risks that can fall under the same definition. A trader needs to understand the overall economic performance of the traded currencies. We trade currencies in pairs, and therefore, we need to understand the overall economic health of their respective countries.

Understanding the main economic indicators, including but not limited to inflation, growth, and labor market trends, can help traders set expectations about what actions a central bank may take. FX exchange rates are heavily influenced by interest rates, and being aware of where interest rates are heading can help traders identify the main trend and customize their risk profile accordingly, regardless of their strategy type.

For example, forex pairs showed significant price swings over the past few weeks due to Trump’s tariff impact expectations. Currency pairs were impacted differently, each according to how much the potential impact is on their respective economies. This leads us to the fact that we need to be aware of the scheduled news on the economic calendar, which helps traders anticipate potential trend changes or higher volatility.

The above chart for USD/CAD highlights how the currency pair was impacted by the tariff announcements and negotiations from the day Donald Trump won the elections to the so-called liberation day, Wednesday, April 2nd, 2025.

Other types of market risk can be associated with the nature of a specific currency pair. For example, since Canada is a major oil producer and exporter, a currency pair including the Canadian dollar may be impacted by a change in crude oil prices.

Understanding the main driver behind FX exchange rate fluctuations can help traders draw correlations between different currency pairs. Currency pairs do correlate to a certain extent; the correlation changes over time, but it is always there.

There are many examples of political risk. It can vary from peaceful democratic elections to wars between countries, and all can impact the forex exchange rates and financial markets in general. A recent example of an election impact was, of course, the US election. Speculation on the anticipated policies for the new US administration caused significant moves and higher volatility in the FX markets, as traders continued to speculate on how the new administration will go about tax cuts, inflation, government spending, and tariffs and how this will impact the economy and the US dollar.

Another example of a different type of political risk is the war in Ukraine. In November 2021, approximately four months before the invasion began, reports about Russian troops built up along the border began to emerge. The US and other countries warned that Russia would invade Ukraine. The FX markets' reaction could be seen in different pairs.

To the far left of the above chart, we can see how the war in Ukraine negatively impacted EUR/USD. The drop in the EUR/USD exchange rate began around the same time when the Russian troops began the buildup at the borderline. It is also important to say that the Federal Reserve started raising interest rates on the US dollar in March 2022, impacting the EUR/USD exchange rate.

To the far right of the chart is another example of how political risk can impact currency prices. The US election results set the expectation that inflation may remain higher for longer due to spending, tax cuts, and tariffs. This led to an increase in the US dollar exchange rate against other currencies. The chart shows how EUR/USD dropped against the US dollar.

Market liquidity risk refers to the risk of disappearing liquidity in the market. The impact can vary significantly depending on the risk event itself. It can range from a major liquidity shortage event that leads to a trading halt, such as the Swiss National Bank monetary policy changes in January 2015, to a brief liquidity skew during a scheduled news announcement or the daily rollover time.

FX trading is available 24 hours a day, 5 days a week. Still, there are certain times when liquidity can be less than others, for example, at the markets open on Sunday at 5 PM EST, when New Zealand and Australia are the only places open for business due to time zone differences. The same can be said for the daily rollover time at 5 PM EST, when a trading day ends and a new one begins (it can be different for certain currencies/instruments). Less liquidity at rollover time can be expected, leading to wider spreads and the possibility of slippage. Other times when traders may face liquidity risk is when they attempt to place a trade during or at the time of a major news announcement, especially if the news release is significant. There are also seasonal times when liquidity can shrink, such as around the new year.

The above chart is for EUR/USD historical spreads. It reflects how low spreads are during the entire trading week, except for the daily short duration at the rollover time. The chart also highlights how spreads may widen during a news event. Understanding liquidity for a specific currency, as well as times when it can be heavily impacted, can help reduce this type of risk.

It was around 3 PM EST at the office on an early spring day in New York when the sad news about the South East Asia Tsunami came in. Unexpectedly, and although the disaster hit Japan hard, the Japanese Yen's status as a haven currency caused it to rise by approximately 8% as the news was released. A week later, as the devastation was known, the Japanese yen dropped, falling back to and beyond its initial levels before the disaster.

One of the key risks that some new traders face is counterparty risk. Having an account with a regulated broker adds a layer of protection that can significantly reduce this type of risk.

The Commodity Futures Trading Committee, the CFTC, and the National Futures Association, the NFA, have regulations in the United States that guide brokers' activities and protect US traders. However, some new traders may decide to open their accounts with unregulated overseas brokers and only realize the fault after it is too late.

A common saying in the FX market is that traders' worst enemies are themselves. We are all human and vulnerable to emotions such as fear or greed, which may lead to random trading decisions. Over the time I’ve worked with traders, I saw how many, including myself at times, can easily get hooked up to an idea or a specific market expectation.

In other words, a trader's bias can negatively influence their trading decisions. I learned about many types of biases through the Chartered Market Technician designation, the CMT.

Each trader should manage emotional biases individually because we are all different. A trader must attempt to identify whether their analyses are biased towards a specific outcome. It is important to consider contrary opinions and gauge how both scenarios may impact a trade.

It takes time and a lot of practice to get there. Over time, traders can be able to identify their biases more informedly, which can help improve their performance.

“A perception bias arises when an individual has difficulty figuring out what the problem is that needs to be solved. Perception biases come in many forms.

Saliency - When we have not encountered something recently, we have a tendency to ignore that thing even if it is important to an upcoming decision. No one seems interested in buying flood insurance unless there has been a recent flood.

Framing - The correct answer to a question should not depend on how the question is phrased. Unless the alternative way of asking a question is truly different, the answer should be independent of phrasing or framing.

Anchoring - Anchoring is a perception bias that arises when you are attempting to make a guess at something about which you have limited information. An anchor biases your guesses in the direction of the anchor.

Sunk-Cost Bias - Imagine that you paid $200 for a non-refundable common entrance variable ticket to see a great country-and-western singer– your favorite– perform next Thursday. But when Thursday rolls around, you no longer want to go. You've decided you don't like that singer after all. You try to give away your ticket or sell it, to no avail. So do you go to the performance even though you no longer think that you would enjoy it?”¹

Source: CMT 2020 Curriculum level II, Chapter 19 Perception Bias

In forex trading, we experience the above biases daily. A trader may be anchored to an incorrect long-term forecast for a specific currency, which can negatively influence other trading decisions.

An example of the sunk-cost bias is when a trader holds on to a losing position more than it is supposed to be, hoping that the market will turn around at some point, which it might do. However, this bias may also negatively influence other trading decisions or result in lost opportunities as the trader's mind remains overwhelmed by the losing open position.

No matter how small or large a trading capital is, without proper money management, the odds of the risk of ruin are almost guaranteed. A trader may have a successful strategy and no bias but lack adequate money management techniques.

Money management is key regardless of the type of trading strategy utilized, whether it’s a high-frequency automated strategy, manual swing trade setups, or even a long-term trade based on fundamental expectations.

Each trading strategy has its parameters, which include an entry price, a stop loss level, and a profit target. This means that a trader needs to consider these parameters when deciding their trade size.

They would need to ensure that their account size would sustain such risk. A trader will also need to consider the total number of trades that they expect to have open at the same time, for example, running an automated trading system based on a set of specific indicators, a trader would need to run enough back testing to ensure that they have an understanding of the total number of trades and allocate capital accordingly.

A trader must also understand that using higher leverage simply means that they won’t be able to hold a position if the market becomes more volatile than it normally is. For example, during a news announcement or a time of uncertainty when volatility tends to be higher than its averages, utilizing maximum leverage may lead to losses as a result of the higher volatility, even though market prices may return to where they were originally.

1. Leverage is a double-edged sword; utilize appropriate and effective leverage.
2. A reasonable entry price is key; it allows for an appropriate stop loss and take profit targets, resulting in a better risk-to-reward ratio.
3. Be aware of the country's overall market conditions and economic health for the currencies being traded. We also need to be mindful of the scheduled news events on the economic calendar.
4. Have an understanding of currencies’ correlations to other markets and how they may impact one another.
5. An understanding of the current political situation may help identify political risks at an early stage.
6. Consider market volatility for each currency pair independently.
7. Know yourself better, eliminate biases or keep them in check, and consider contrary opinions.
8. Money management: do the math to avoid surprises.

Footnotes

¹ Chartered Market Technician

From Edwin T. Burton and Sunit N. Shah, Behavioral Finance (Hoboken, New Jersey: John Wiley & Sons, 2013), Chapter 10.