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Risk management fundamentals

Prudent risk management is an essential part of trading. 

Capital is required to speculate on the financial markets and it’s important that your funds are managed effectively.

As markets move up as well as down, they can also move in your favour or against you, so having a game plan can help you to get the most out of your money.

A common mistake traders make is to spend too much time thinking about how much money they could make, while overlooking the fact that they might lose money on a trade. My mantra is: the second aim of trading is to make money, but the first aim is not to lose money.

In the business world they say, “fail to plan; plan to fail”, and trading is no different in that you should have a strategy. Map out what you expect to happen and formulate your entry and exits points around that. Writing down your trading ideas can be a useful exercise, as it allows you to examine the strength of your own thoughts. Map out how you see events unfolding, and pinpoint possible entry and exits prices that suit your strategy.

The basics of technical analysis can help you select entry and exit points for trades. Looking out for areas of support (a price where a market has bounced back after a decline) or resistance (a price where the market has pulled back after a rally) may provide assistance when determining potentially important prices. Prices near important trendlines can also commonly be used for opening or closing trades.

A sensible approach to managing your risk is to establish a reward to risk ratio from the outset, and then apply it to your entry and exit price strategy. When placing a trade you should be aiming to make at least twice as much money as you are risking. For example, you may enter a trade with the view of making £200 on the transaction, and you are comfortable risking £100 on the trade. 

It is often cited that professional traders at major investment banks only get approximately 40% of their trades right, as they have the discipline to cut a losing position, and book profits on winning trades. A common mistake for less experienced traders is to run large losses, while cutting winning trades too early. Risking too much money for a potentially small profit isn’t sensible.

Taking the example of the 2:1 reward to risk ratio, you will break even if you only get one in three trades right. A 3:1 reward to risk ratio only requires you to get one in four trades right to break even. The higher the reward to risk ratio, the fewer trades you need to get right to break even.

Having the discipline to cut a trade that has gone against you is important, but you must also be willing to take a profit too. Remember, it isn’t a profit until the position is closed out. Leaving profitable trades open and holding out for even more profit than you originally predicted is also a common mistake novice traders tend to make.

In this respect, effective use of order types can give you more control over managing your risk. These include regular stop-loss orders, which specify a price your position will be closed out should the market move against you. You can also choose to add a guaranteed stop-loss order (GSLO), which gives you 100% certainty that the stop-loss will be executed at the exact price you have set, for a premium, which is refunded if the GSLO is not triggered. Other order types can help protect a profit, such as trailing stop-loss and take-profit orders.

Make sure the money you have earmarked for risking on a certain trade is a relatively small amount of your trading account total. Risking too much per trade can be costly, and as capital is essential for trading, you must remain solvent to deal on the markets. Some traders start off risking minimal amounts of money, and as they progress and start to make a profit, gradually increase the size of the amount that is risked per trade.

Having a few trades open at a time can be a good way to diversify your risk, as long as you don’t have too many trades open to keep track of them all. It is also practical to hold positions that don’t have a high positive correlation. For example, the Dow Jones and S&P 500 often move in the same direction and by a similar magnitude, so if a trader had a long position on both markets, they could be relatively over-exposed to US equity markets.   

Trading is a skill, and like any skill it takes hard work to improve. You learn from the mistakes and build on your experiences. Forming a good risk-management strategy is vital, as it teaches you to use your funds effectively. There are a number of approaches to risk management and it’s important to find what works best for you. Visit our learn section for more information.

CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.

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