What is risk management?

With CMC Start you have negative balance protection, which means you cannot lose more than the funds in your account.

However, you can still lose all the funds in your account, therefore risk management is still an important part of your trading strategy.

Why is risk management important?

Even strategies that have been successful over the long term can leave you vulnerable to risks in the short- to medium-term, including:

• Significant runs of consecutive losses
• Occasional large losses where prices gap through stop-loss levels, for example due to a major news event
• Changes in market circumstances – unfortunately you can never be certain that just because a strategy has worked in the past it will continue to work in the future

Without appropriate risk management, events like this can lead to:

• Loss of all of your investment
• Having to close positions in your account at the wrong time because you don't have enough liquid funds available to cover margin
• The need for an extended period of profitable and prudent trading just to recover your losses and restore your trading capital to its original level

Given the nature of trading, there is still the possibility that the above scenarios can arise, even after you’ve used the appropriate risk management strategies. After large losses, some traders resort to taking even greater risks, and this can lead to ever-deepening difficulties.

To get the benefits of a winning strategy over the long term, you need to be in a position to keep trading. You can't avoid risk as a trader, but you need to preserve capital to be able to make money.

A risk-managed approach to trading recognises that you are taking risk but need to limit that risk in the short term, in order to maximise longer-term opportunities. Lack of risk management is one of the most common reasons for failure.

Risk and leveraged trading

CFD trading uses leverage, and leveraged trading itself can be a double-edged sword – it magnifies potential losses as well as potential profits. This makes it even more important to limit your exposure to large adverse market moves, or a larger-than-usual string of losses.

Risk management rules can sometimes reduce profits over the short- to medium-term. The temptation to abandon prudent risk management is often greatest after a period of success, but even a single large leveraged trade which goes against you, could result in a loss of all your recent hard-won profits.

A consistent, controlled approach to trading is more likely, but not guaranteed to be successful in the long run. Prudently increasing your positions in line with your increased capital is a more likely path to success than overtrading in the short term.

Good risk management can also improve the quality of your trading decisions, by helping with your psychological approach to the market. Getting into a cycle of overconfidence, followed by excessive caution, is a common problem for traders. Trading without risk management makes this more likely.

How can I manage my risk?

The knowledge that your trading strategy is backed by a good set of risk management rules can be a big help in avoiding the cycle of euphoria and fear that often leads to poor decision making.

Limit your trading capital

The first thing to decide is how much capital you will devote to trading. Invest only what you can afford to lose.

Some of the factors you may wish to consider include your:

• Overall financial situation and needs
• Trading objectives
• Tolerance for risk
• Previous experience as an investor or trader

Wealth preservation should be a key consideration. Remember that with CMC Start you have negative balance protection, so cannot lose more than the funds in your account. But you should consider how big an investment you would feel comfortable losing if you do make a loss.

Conduct your own stress test

A useful technique in deciding on how much capital and risk to allocate is to conduct your own stress test. Calculate the worst-case loss if there were a very big market move, or a large string of losses at a time when you have your maximum position open.

Decide whether you could afford this and if you could deal with it emotionally, remembering that it’s possible to lose all of the funds in your account. Limit your trading position to something you can handle in these circumstances. Even if you’re comfortable with the overall risk you take, it’s best to make sure you have enough funds in your account, or available at short notice, to support your trading activities at all times.

When you're new to trading, it can be prudent to start in a relatively small way and plan to increase your trading activities once you’ve developed some experience and a track record of success.

Using stop-loss orders

Successful trading involves balancing risk and reward. Good traders will always work out where they will cut the loss on a trade before they enter it.

It is good risk-management practice to have a stop-loss order in place for every position you open, and it is best to place the stop-loss order at the same time you place the trade.

Stop-loss orders

Stop-loss orders allow you to specify a price at which a position will be closed out automatically if the market moves against you.

It’s important to know that stop-losses are subject to slippage and may be filled at a worse price than the level set in the order. The risk of slippage means that a stop-loss order cannot guarantee that your loss will be limited to a certain amount.

What is slippage?

One common reason for slippage is when the price gaps in response to a major news event. For example, you may set a stop-loss at £10.00 on XYZ company CFDs when they are trading at £10.50. If XYZ company announces a profit downgrade and the price falls to £9.50 before trading again, your stop-loss order will be triggered because the price has fallen below £10.00. It then becomes a market order and is sold at the next available price. If the first price at which your volume can be executed is £9.48, your sell order would be executed at that price. In this case you would suffer slippage of 52 pence per CFD.

Even though stop-loss orders can sometimes be subject to slippage, they are a vital and useful risk-management tool.

How to add stop-loss orders

The CMC Start app is designed to assist you with a risk/reward approach to trading. You can add a stop-loss order, trailing stop-loss order, or a guaranteed stop-loss order via the order ticket when you open a new position. When adding a stop-loss order, you can choose between the stop-loss level you want to be closed out at, or the amount of capital which you are willing to lose.

Advantages of using stop-loss orders:

• You control your risk and reduce the chance of large unexpected losses that can catch you off guard without a stop-loss in place
• You’re using a disciplined approach to trading – placing a stop order makes you consider where to cut losses before you enter the trade
• It helps you to assess risk and reward
• You can measure the profit or loss achieved on each trade against original potential loss (this is the difference between your entry price and original stop price)
• You may decide not to enter some trades if the profit potential is too small compared to the initial risk
• It helps with time management – stop-loss orders are triggered automatically meaning you don't have to be glued to your phone monitoring your trading positions

Guaranteed stop-loss orders (GSLOs)

One way to combat the effects of slippage is to place a guaranteed stop-loss order. GSLOs are an effective way of safe-guarding your trades against slippage or gapping during periods of high volatility. For a premium, CMC Start’s GSLOs give you 100% certainty that your stop-loss will be executed at the exact price you want, regardless of market volatility or gapping. We will refund 50% of the premium if the order is not triggered. Find out more about GSLO costs

Trailing stop-loss orders

Stop-loss orders are an effective risk management tool, but they can also be used to take profits. For example, a common strategy is to move your sell stop-loss higher as the market moves higher. This is done by applying a trailing stop-loss, which will follow a price as it moves favourably for you, remaining at the distance specified when the order was placed.

Finding the balance between risk and reward

If you’re aiming to succeed as a trader, the size of your potential losses should make sense compared with the original profit potential on each new position.

Long-term trading profit can be described as a winning combination of:

• The number of profitable trades, compared with the number of losing trades, and
• The average value of profits on each trade compared with the average value of losses

It’s important to combine these ratios and the relationship between risk and reward. One way to evaluate risk versus reward is to consider the potential approximate loss of each trade compared to the overall funds in your account.

Using fixed percentage position sizing

Fixed percentage position sizing involves calculating the position size on each new trade, so that the loss at the initial stop-loss level equals a fixed percentage of the funds in your account, such as 1% or 2%.

For example, a trader with £500 in their account might set the size of each new position so that the loss at the initial stop-loss order is no more that 2% of their capital, or £10.

Our CMC Start app calculates the potential approximate loss if the price falls to the stop level you set.

Benefits of fixed percentage position sizing:

• It’s a logical method of relating position size to risk
• Your positions automatically become smaller if you suffer losses, helping to preserve your trading capital
• It provides a method of gradually increasing your position size as you make money, which can help your trading capital grow steadily while maintaining the same percentage risk level

One of the things to consider when setting your position size percentage is how much of your trading capital you would be prepared to lose after a very large string of consecutive losses. For example, using 1%, you would lose 13% of your capital after 14 consecutive losses. Using 2%, you would lose 25% of your capital if you had 14 straight losses.

This rule aims to defend your trading capital if you have positions open when there is a single adverse market event.

For example, traders using fixed percentage position sizing of 1.5% may set themselves a rule that they will not have more than 10 or perhaps 15 positions open at any one time. Assuming there is no slippage, this means their loss would be no more than 15% or 22.5% of their trading capital if they lost on all the positions. It's up to you to set the limit that you feel is appropriate for your circumstances and trading.

What to consider when trading closely related instruments

Diversification is important for traders – you should not have all your eggs in one basket.

You may consider having no more than two positions net long or short in closely related instruments. Net long refers to the difference between your total long and total short positions, for example, six long and four short positions means you are net long two positions.

Examples of closely related instruments would include:

• Foreign exchange pairs involving the same currency, for example, EUR/USD, GBP/USD, USD/JPY, USD/CHF, AUD/USD
• Shares in a single industry and listed on the same exchange, for example, UK bank shares
• Closely related commodities, for example, wheat, corn and soybean

Set an upper limit on total losses from a single strategy

Traders sometimes tend to use different trading strategies. It pays to draw a line on a single set of trading rules if it loses too much of your capital.

One useful approach can be to set smaller limits for new strategies, but to be more tolerant with a proven strategy that you have used successfully over a long period of time and where you are familiar with its risk history, including the likely number of consecutive losses and stop-loss slippage.

Disclaimer

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.