Learn how to manage risk
No opportunity comes without risk and all traders, even the most successful ones, will lose money on numerous occasions. However, losing or missing out on an opportunity isn’t the same as wiping out your capital in a single transaction or investing money you can’t afford to live without. This is where risk management comes in. Experienced traders use risk management techniques because they acknowledge that you can’t always win, and you should follow in their footsteps.
In previous lessons, we discussed some broad risk control strategies, e.g. we discussed the important of understanding macroeconomic decisions and how they make affect your assets, and we also covered the importance of being realistic about how much time you can dedicate to trading . If you can’t monitor the market regularly, you should steer away from short-term trading, which requires rapid entry and exit, and focus on medium to long-term positions instead. If you don’t care about the market at all, you should consider investment as opposed to trading. The former implies you’re building a portfolio over time that includes different assets, which you could actually own, whereas trading is more about frequent buying and selling based on speculation about the price movement of assets.
So how do I protect myself from risk?
Traders use a number of techniques, some of which don’t require professional training. In fact, we’d argue that most risk management strategies are common sense but trading isn’t just about figures and data. Emotion is a huge part of decision making and you may act based on greed or hope, rather than objective criteria. So, risk management is also about controlling your feelings when your money is on the line.
- Start by developing a trading plan and, most importantly, stick to it. As the saying goes, “plan your trade and then trade your plan”.
- Don’t throw your entire capital in one transaction, no matter how amazing the opportunity seems. In other words, don’t put all your eggs in one basket. Most traders will never invest more than 5% of their account balance in a single trade.
- Hedging is a great way to cut your losses, in case the market moves against you. I.e., if you invest in an instrument hoping its price will rise, take out a CFD on the price dropping. One of the two trades will pay off.
- Trade during peak hours when liquidity is higher.
- In leveraged trading , make sure your maintenance margin remains strong. Otherwise, your position may close unexpectedly.
- Use orders , such as “stop loss” or “take profit”. These are instructions to sell when the price reaches a certain point. With “stop loss”, you accept the loss but protect yourself against further price drops. “Take profit” will be activated when an instrument reaches a certain price so you’ll take the money and run accepting that the upward trend might continue. These orders help you control your emotion, sometimes it’s better to cut your losses than hope things will change and it’s also better to consolidate your profits rather than greedily wait for a never-ending upward trend.
- Determine your risk:reward ratio. How much risk are you willing to take and what’s the reward you’re anticipating? E.g., if your risk:reward ratio is 1:2, you expect to make $10 for every $5 you put in.
So, risk management isn’t about limiting opportunities or being pessimistic. It’s about accepting that loss is inevitable and embedding this principle in your trading strategy.
Bitesize basics
- Losing is part of trading but risk management will help you maintain a sustainable portfolio.
- Start with the broader picture. Trading requires you to monitor the market so, if you don’t have time for this, you may want to look at long-term investments.
- Popular risk management strategies include developing a trading plan, never investing more than 1%-5% of your capital in a single transaction, using “stop loss” and “take profit” orders, hedging and determining an acceptable risk:reward ratio.
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