Managing risk is crucial for a successful trading strategy, but it's often neglected. By using risk management methods, traders can minimize the negative impact of losing positions on their portfolio's value.
Continue reading to discover:
- The significance of risk management
- Ways to handle risk in trading
- Tools for managing trading risk
WHY IS MANAGING RISK IN TRADING CRUCIAL?
Many traders view trading as a chance to earn money, but the possibility of loss is often ignored. By using a risk management plan, a trader can reduce the negative impact of a losing trade when the market moves against them.
A trader who includes risk management in their trading strategy can profit from upward movement while limiting downward risk. This is done through the use of risk management tools like stops and limits, and by trading a diversified portfolio.
Traders who choose not to use trading stops risk holding onto positions for too long, hoping the market will turn around. This is the biggest mistake traders make and can be avoided by applying successful trader traits to all trades.
MANAGING RISK IN TRADING: BEST PRACTICES AND STRATEGIES
Here are six risk management methods that traders at all levels should think about:
- Identify the risk/exposure beforehand
- Ideal stop loss placement
- Diversify your portfolio: the less correlated, the better the diversification
- Keep risk consistent and control your emotions
- Maintain a positive risk-reward ratio
1) Identify the risk/exposure beforehand:
Every trade carries risk, so it's important to determine your risk before entering the trade. A common guideline is to risk 1% of your account equity on a single position and no more than 5% across all open positions at any time. For example, applying the 1% rule to a $10,000 account means risking no more than $100 on a single position. Traders must then calculate their trade size based on the distance of the stop to risk $100 or less.
This approach helps preserve account equity after a series of unsuccessful trades. Another advantage is that traders are more likely to have free margin available to take advantage of new market opportunities, avoiding missed opportunities due to margin being tied up in existing trades.
2) Ideal stop loss placement
Traders can use many different methods to decide where to place a stop.
Stops can be set according to:
- Moving averages – set stops above (below) the specified MA for long (short) positions. The chart below shows how traders can use the moving average as a dynamic stop loss.
- Support and resistance – set stops below (above) support (resistance) for long (short) positions. The chart below shows the stop placed below support in a ranging market, giving the trade enough space while guarding against a significant downward movement.
- How to Use the Average True Range (ATR) - ATR shows the average change in price for any security over a certain time and helps traders to choose how far away to place their stops. The chart below uses a careful method with the ATR by putting the stop distance based on the highest ATR value from the latest price movements.
*Extra Advice: Rather than using a fixed stop loss, traders can use a trailing stop to lower risk when the market is going their way. The trailing stop adjusts the stop loss higher on winning positions while keeping the stop distance the same at all times.
3) Diversify your portfolio: The less correlated, the better the diversification
Even if you follow the 1% rule, it's important to know how positions may be correlated. For example, the EUR/USD and GBP/USD currency pairs have a high correlation, meaning they tend to move together and in the same direction. Trading highly correlated markets is great when trades move in your favor, but it becomes a problem on losing trades because the loss on one trade now applies to the correlated trade as well.
The chart below shows the high correlation between EUR/USD and GBP/USD. Notice how closely the two price lines track each other.
Having a good understanding of the markets you're trading and avoiding highly correlated currencies helps achieve a more diversified portfolio with reduced risk.
4) Keep your risk consistent and control your emotions
After making a few winning trades, greed can easily set in and tempt traders to increase trading sizes. This is the easiest way to burn through capital and put the trading account at risk. For more experienced traders, it's okay to add to existing winning positions, but maintaining a consistent framework for risk should be the general rule.
Fear and greed often arise when trading. Learn how to manage fear and greed in trading.
5) Maintain a positive risk-reward ratio
Maintaining a positive risk-reward ratio is crucial for managing risk over time. There may be early losses, but maintaining a positive risk-reward ratio and sticking to the 1% rule on each trade greatly improves the consistency of your trading account over time.
The risk-reward ratio calculates how many pips a trader is willing to risk compared to the number of pips a trader will receive if the target/limit is hit. A 1:2 risk-reward ratio means the trader is risking one pip to make two pips if the trade works out.
The magic of the risk-reward ratio lies in its repeated use. Our Traits of Successful Traders research found that traders who used a positive risk-reward ratio tended to show profitable results compared to those with a negative risk-reward ratio (page 7 of the guide). Traders can still be successful even if they only win 50% of their trades, as long as they maintain a positive risk-reward ratio.
One possible way to rewrite this paragraph is:
*Extra Tip: Traders sometimes feel annoyed when the trade goes the right way only for the market to reverse and hit the stop. One method to prevent this is to use a two-lot system. This technique closes half of the position when it's halfway to the target and then moves the stop on the rest of the position to break-even. This way, the trader makes profit on one position while basically having a trade with no risk on the rest of the position (if using a guaranteed stop).
TRADING RISK MANAGEMENT TOOLS
1) Regular Stop Loss: These stops are the standard stops offered by most forex brokers. They work best in non-volatile markets because they're prone to slippage. Slippage occurs when the market doesn't trade at the specified price, either due to a lack of liquidity at that price or a gap in the market. As a result, the trader must take the next best price, which may be significantly worse, as shown in the USD/BRL chart below:
2) A guaranteed stop loss: It ensures that the broker will honor the exact stop level, even in volatile markets where prices can fluctuate rapidly. This feature comes at a cost, as brokers charge a small fee to guarantee the stop level.
3) A trailing stop loss: It adjusts the stop level closer to the current market price as a position becomes profitable, while maintaining the same initial stop distance. For instance, in the GBP/USD chart below, a short entry is shown to be successful. As the market moves in increments of 200 pips, the stop level automatically adjusts, while keeping the initial stop distance of 160 pips.
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