Risk management

Risk management is a crucial aspect of trading. In short, the aim of risk management is to minimize potential losses without relinquishing upside potential. This quick guide covers the essential risk-management techniques you need to know about. You’ll learn what the main trading risks are and how to manage them using a range of tools and strategies

What is risk in trading?

There are various risks associated with trading complex derivative products like contracts for difference (CFDs). Below, we summarize the key risks to be aware of.

Leverage risk

Perhaps the main risk that comes with trading CFDs is that you could lose money rapidly due to leverage. First, a quick recap of what we mean by ‘leverage’. Leverage is the use of borrowed money to enlarge your financial position and increase the potential return of a trade. One feature of CFD trading is that you can trade on margin, meaning that you put up a fraction of the full value of the position to open a leveraged trade. When you open a leveraged trade with a broker, you deposit the margin while the broker provides the rest of the notional value of the position. While leverage can amplify potential returns, it also amplifies potential losses because your profit or loss is based on the full notional value of your position. The risk, then, is that trading with leverage means you could make large losses if the market moves against you.

Market volatility risk

Financial markets can be volatile. The price of financial instruments may change rapidly and without warning due to factors beyond your control, such as a surprise economic announcement. While sudden and unexpected price swings can bring potential opportunities, there’s also the risk that prices might move against you.

Currency risk

You may be exposed to currency risk, also known as exchange-rate risk, if you fund your account with one currency – say, Canadian dollar (CAD) – and trade on an instrument priced in a different currency, such as US dollars (USD). For example, a USD-denominated trade could appear to be in profit, but if USD weakened against CAD after you placed the trade, you could end up incurring a loss when you close the trade and the trade value is converted back into CAD.

Margin call risk

A margin call is a risk-management feature designed to ensure that a trader has sufficient funds in their account to cover potential losses. If your account value falls below a certain threshold, a margin call may occur. Essentially, this is a request to add funds or reduce your positions in order to continue to meet minimum margin requirements.

Trading on emotion

It can be risky to trade when you’re not in the right frame of mind. If you chase losses, or if your trading is driven by anger, fear or greed, you may make rash trading decisions. Emotionally charged, poorly researched trades can result in losses.

Liquidation risk

Your position(s) could be automatically closed if your account value falls below a minimum margin requirement. You may sustain losses as a result of the close-out.

Lack of knowledge

Traders who don’t understand financial markets may make poor trading decisions. As a result, they run the risk of incurring losses.

What is risk management?

As we mentioned at the outset, risk management is about trying to minimize potential losses while not giving up on the potential for gains. While the risks of trading cannot be eliminated entirely, when managed correctly the risks may be kept to a level that you can handle. Most traders use a mix of tools and strategies as part of their risk-management plan – a set of rules that guide a trader’s decisions and help him or her mitigate the risks of trading. A solid risk-management plan should consider the following:

Stop loss orders

Position size

Diversification

A stop-loss order is an instruction to offload an asset automatically if its price moves against you and reaches an exit point that you’ve set. In this way, stop-loss orders – which we’ll look at more closely in the next section – allow you to limit losses if a trade doesn’t pan out as you’d hoped.

Keep leverage to a reasonable level by managing your position size. If you open a large position relative to your account size, small declines in the instrument’s price could have a significant negative impact on your account value.

Don’t put all your eggs in one basket. Spread your risk across multiple assets, sectors and regions to reduce your exposure to downturns in a given area. Diversification can also open your portfolio up to potential opportunities.

Risk management tools

Having established what the main risks of trading are, and what risk management aims to achieve, let’s now explore some common approaches to managing risk. We’ll begin with a look at some of the key risk-management tools that we offer on our trading platform, before moving on to the risk-management strategies that you could consider implementing as part of your risk-management plan.

Stop loss order

Trailing stop loss order

Guaranteed stop-loss order

Limit order

Price alerts

You can add a stop-loss order to all your trades with us, allowing you to set a price at which your position closes out if the market moves against you, limiting your losses. With a regular stop-loss order, if an instrument’s price touches the level you’ve set, your position will automatically close out at the next available market price.

Like a regular stop-loss order, a trailing stop-loss order is designed to help you cap your losses if the market moves against you. The difference is that the trailing ‘stop’ is not set at a fixed price. Rather, it adjusts if the instrument price moves in your favour, helping you lock in profits. The trailing stop point is usually a certain percentage or number of points away from the current market price. When the price moves, the stop point maintains the preset distance that you specified.

If you want complete certainty that a trade will close out at the exact price you set, without the risk of slippage, you can pay a premium for a guaranteed stop-loss order (GSLO). The premium is based on the current market price. If the GSLO is not triggered, the premium will be refunded in full. This robust risk management tool can be especially useful during periods of market volatility, when gapping may be a major concern. GSLOs can be cancelled, or switched to a regular stop-loss order or trailing stop-loss order, at any time in our platform.

A limit order is an instruction to execute a trade at a specific target price or better. Limit orders can help you enter or exit a position at a more favourable price than the current market price, allowing you to set the level of risk you’re prepared to accept. For example, let's say you want to go long on, or ‘buy’, shares of Apple. However, you believe the current market price of $250 a share is too high, or too risky. You'd like to buy in at a lower price – say, $235. In this scenario, you could set up a ‘buy’ limit order that would call for a trade to be executed in the event that the Apple share price falls to $235 or lower. The order would remain in place until the stock drops to your target price or you cancel the order.

Our price alerts notify you when an instrument hits a price you’ve specified, helping you to spot sudden or unusual price movements and take appropriate action. Price alerts are free to set up and you can select how you want to receive them (by email, text message, in-platform, or as a push notification on your mobile device).

Risk-management strategies

In addition to the risk-management tools discussed above, there are a number of strategies, or approaches to trading, that you could adopt to help manage risk. Some of the most popular risk-management strategies are outlined below.

Limit your trading capital

Similar to the concept of betting only what you can afford to lose, it’s a good idea to decide how much of your capital you're willing to trade with. Settle on an amount that you wouldn’t miss if you lost it all, and stick to it. You could set a monthly trading budget, or a weekly amount if that suits you better. When coming up with a figure, factor in your:

Overall financial situation and needs
Trading objectives
Risk tolerance
Previous experience as an investor or trader

Conduct a stress test

One useful technique in deciding how much capital to allocate to your trading is to conduct a stress test. Simulate the worst-case scenario for your open positions, taking the potential for extreme market moves into account, to assess whether you could handle the financial and emotional impact of a downturn.

If you sustained a series of daily losses, what effect would that have on both your account balance and your wellbeing? If the stress and financial losses would be too severe, you may be allocating too much capital to your trades, or exposing yourself to too much risk, or both. In that case, try reducing your capital allocation and risk exposure to a level that you could handle even in volatile market conditions. This should ensure that you don’t overextend yourself or trade beyond your limits.

Use fixed-percentage position sizing

Calculate your position size on each trade so that a loss at your stop-loss level equals a small, fixed percentage of your account value, such as 1-2%. For example, a trader with $10,000 in their account might set the size of each new position so that a loss at the level of their stop-loss order is no more than 2% of their capital, or $200.

This method can help you maintain a consistent approach to your trading, while also reducing the potential for significant losses. It also creates a balance between your account value and your risk exposure. If you sustain losses, your next position will automatically be smaller; if you make money, your position sizes will gradually increase.

Cap the quantity of your trades

Limit the number of positions you have open to avoid overexposure. This can help protect you against the potential negative impact of a single market event.

For example, traders using a fixed-percentage position size of 1.5% may set themselves a rule that they will not have more than 10 positions open at any one time. This means their losses would be at most 15% of their trading capital if they lost on all the positions, assuming no slippage. It's up to you to set the limit appropriate for your circumstances.

Diversify your positions

Spread your risk across different assets, markets and sectors. Avoid concentrating your positions in closely related instruments, such as several trades involving the same currency or commodity.

Finding the right risk-management techniques for you

In this article we’ve explored the concept of risk in trading, and looked at several tools and strategies to help you manage those risks. As you develop your own approach to risk management, why not use your demo account to practice applying some of the techniques we’ve looked at? When you’re ready, you can apply what you’ve learned to live trades.

Remember, every trader is unique, and your risk-management plan should align to your personal circumstances, trading goals, risk tolerance, level of experience and trading style.

In closing, here are some of the key points to bear in mind as you develop your own risk-management plan:

Remember your risk tolerance: Don’t expose yourself to more risk than you can handle. Set limits and only place trades you can afford to lose.
Start small and adjust: New traders should begin with small positions and gradually scale as they build experience.
Consistency matters: The best traders consistently apply risk-management techniques, helping to protect their capital in both favourable and unfavourable market conditions.