Insights

Importance of Risk Management in Forex Trading

November 4, 2016

Risk-management is a notion that defines trading in general and it should be interpreted on both sides: trader’s and broker’s side as well. The whole industry is a risky one and there is virtually no forex broker that is not displaying the risk disclaimer on the first page of its website, stating that trading leveraged products is a risky thing.
From a trader’s point of view, risk can be managed in multiple ways:

  • Trading with as little leverage as possible;
  • Applying sound money management techniques (risking only a small portion of the overall trading account, use realistic risk-reward ratios like 1:2.5, or maximum 3, avoid overtrading, avoid trading correlated pairs, etc.).

From a broker’s point of view, though, managing risk is a bit more complicated as it depends very much on the type of the brokerage house and the methods used for providing the retail traders their day to day quotations.

Based on the risk management approach, brokers are being divided into A-Book and B-Book brokers, based on the way they are managing it. Managing risk is different in these two situations, and below there’s a small explanation about how brokers are doing it.

Risk Management in A-Book

In forex trading, it is possible for the broker to take the other side of the trade when compared with the customer’s trades. This means that if a client goes, for example, long the EURUSD pair, the broker will go short the same volume and the other way around.

This is where the difference between the A and B book comes. The A-booking happens when brokers pass their customer’s trades through a liquidity provider. In this way, the broker is profiting by charging a small commission on the customers’ accounts. It doesn’t matter if the client is making or not a profit, the broker, in the end, will earn the same amount: the above-mentioned commission.

Brokers that are involved in A-booking are brokers that use the STP and/or ECN technology. With A-booking there is no conflict of interest between the parties involved in the trading process.

It is not the same thing with brokers that operate a B-book.

Risk Management in B-Book

The B-book refers to the process of keeping the client’s trades on the broker’s book, without passing the trades through a liquidity provider. This way the brokerage house takes the other side of the trades taken by the retail clients and the amount of profit/loss is directly proportional.

Considering that retail traders mostly lose than win, taking the other side of their trades and keeping the orders in house shows a very profitable business for B-booking brokers. This brings into question though the morality of the business as there is clearly a conflict of interest between B-booking brokers and their clients.

Such brokers have special trading departments to handle the trades and even engage in other risk management techniques like internal hedging and other swap arrangements when things are going on the wrong way.

All in all, running a B-book these days is mainly happening at brokers that opt for a mix between the two risk management systems, with the emphasis being on the A-book system. With trading becoming more and more popular and traders more and more knowledgeable, basing your entire risk management for your brokerage house only on B-booking is becoming riskier than the overall strategy itself.

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