Those who can manage winning and losing investments over time are the ones who achieve real consistency to their trading results. Put simply, risk management is the way a trader handles the inherent risk of losing money when trading.
What is Trading risk management?
If market analysis can be thought of as finding opportunities to win. Trading Risk management can be thought of ways to minimise loss. Both are equally important. Any potential trade must meet your market analysis and risk management rules.
To prevent larger losses in a losing trade, there are practically only two steps that can be taken. You can either close the trade or hedge the trade. When closing the trade, the loss is realised, the trade has finished and the capital used to fund the trade is free to use for other opportunities.
Stop Loss orders
A convenient way to cut the loss on an open trade is to use a stop-loss order. This order will automatically execute at a pre-determined price level. Using a stop loss adds peace of mind and enforces discipline into the trading. Nobody likes to lose, but losses are a part of trading. The important thing is to have small losses, not big ones.
When hedging, an opposing position is taken out, locking the loss at a fixed size. As one trade wins, the opposite trade loses. By doing this the trader defers the decision about what to do with the losing trade.
Risk Management strategy
A strategy for risk management needs to consider these 3 variables:
1) Position sizing (2% rule)
2) Risk to reward ratio (2:1 rule)
The idea behind position sizing is to only risk a small percentage of your account on each trade. That way when a string of losing trades occurs, although undesirable- the trader still has funds to continue trading and the opportunity to recover the losses. 2% per trade is the rule of thumb.
The risk to reward ratio, is a fancy way of saying- how much will you make if you’re right versus how much will you lose if you’re wrong. It’s a way to enforce the old trading adage of “cut your losses short and let your profits run.” The rule of thumb is 2:1 - meaning the win should be twice as big as the loss.
Finally diversification in trading means not placing trades that are too similar. For example two trades that involve buying the dollar against another currency are likely to see similar results- essentially making it a double-sized trade on the dollar.