Risk management refers to the processes that are put into place when trading to help keep losses under control and keep a good risk/reward ratio.
Risk management can help prevent a trader from losing all their money on the account. Risk management should be applied by both beginners and experienced traders. Before we look at strategies that can be used to manage risk on the account let’s first consider why risk management is so important when trading and investing.
Trading is risky that is how it offers a high potential reward. This is especially true when using leveraged products. Using leverage means you don’t put forward the full amount of the value of the trade in order to open or run the position. Instead you put forward a small percentage of the value of the trade, called margin.
For example, if the Swiss SMI index has a margin of 5%, you only put forward 5% of the value of the entire trade to open the position. The profits you make relate to the full position size, as do the losses. Using a small deposit, you have access to large profits or losses. This means that it is extremely important to keep control of any losses or you could blow your account very quickly.
Risk management is one of the three central pillars to trading, along with strategy and psychology. Even if you have the best trading strategy (day trading, swing trading...) in the word, perfect trading psychology, without solid risk management losses will start to build up. We know that it is impossible to win every trade, so it is important to keep those trades that are losers under control. This can be done using various risk management tools.
Risk Management Tools
Important aspects of risk management include considering trade size, stop losses, stop loss placement and profit takers and optimal risk reward ratios. Let’s look at each one in turn.
Placing a sensible sized trade in relation to the funds that you have available on your account is the first step towards implementing a sound risk management strategy.
Let’s consider this through an example. You have EUR 10,000 on your account. You open a leveraged trade worth EUR 187,500.
Assuming a margin requirement for a DAX 30 trade is 5%. This means that you must have 5% of EUR 187,500 in your account to open the trade (not including trading costs).
5% x EUR 187,500 = EUR 9375.
If you have EUR 10,000 in your account and EUR 9375 is being used as a deposit to open a position, there is very little room for that trade to move before you will have used your available funds and the position closed by the margin closeout policy.
Let’s consider another example. You have CHF 10,000 in your account and you open a position on the SMI index valued at CHF 37,500. The margin requirement is CHF 1875.
If you have CHF 10,000 on your account and you use CHF 1875 as margin you are giving your trade more room to develop and you will be able to choose where to place the stop loss, rather than the trade being closed out owing to the margin closeout policy.
The 1% Rule
Successful traders don’t look to risk any more than 1% - 2% of their account on any trade. So, if you have CHF 10,000 on your account and you are risking 1% - 2% this means that you are looking to risk CHF 100 - 200 per trade. By taking small risks you will not blow your account up with one or two losing trades. Taking additional risk can be dangerous and detrimental to your long term profits. Part of being a good market strategist is to be discipline and stay cold with numbers.
As mentioned, it is impossible to win every trade but if the ones that lose are only 1% -2% of the account, then the account has much higher probability of surviving. The 1% rule can be adhered through careful consideration of trade size and the use of a stop loss.
Stop loss & Take Profit
A stop loss is an order which closes out your trade when the market price moves beyond a pre-selected level.
For example, your open a buy trade on GBP/USD at $1.2400. You decide to put a stop loss at $1.2300. Should the price of GBP/USD drop to $1.2300 the stop loss order will close it out at the first traded price at or below $1.23.
Using a stop loss, a trader decides how much risk they are prepared to take on and helps you set a pre-specified risk/reward ratio: you know in advance how much you could win and how much you could lose. Effectively placing stop losses is key. This is best done using the structure of the market rather than just deciding that a stop loss should be 50 points away. Popular methods for deciding on stop loss placement include using support and resistance, moving averages or Fibonacci retracement.
Take Profit orders which will close the trade at a profit. If you are long a market, the limit order will be placed above the trade price. If you are short a market, the limit will be below the trade price. Again, best way to decide where to place a profit taker is using the market structure. Planning this level in advance prevents emotions from creeping into the trade and will make you set an optimal risk/reward ratio.
Risk Reward Ratio
I've mentioned that setting decent risk/reward ratio was important, but what does this mean exactly? Once you know where your stop loss and Take Profit will be placed, you can consider the risk reward ratio for the position. As a general rule, successful traders will not consider trades that have a risk reward ratio of less than 1:2, some will only go for trades with a risk reward ratio of 1:3.
This means that the potential reward of a trade much be at least double (1:2) if not treble (1:3) the expected risk. Should the trade not adhere to this rule then the trader simply doesn’t take the position. This is a rule which goes a long way towards preventing overtrading.
Trading any market is risky, especially when using margined products. It is therefore extremely important to implement a solid trading risk management strategy.
In summary, remembering these four ideas will save a lot of trauma
1) trade size in relation to capital available on the account,
2) the use of stop loss and limit orders,
3) sticking to the 1% rule and
4) implementing a 1:2 or greater risk reward ratio.