We are often told that risk management is the key to successful trading. But what does managing risk actually mean and what is the best way of carrying this out?
Broadly speaking there are two types of risk management we should be thinking of: the risk on any individual trade; and the financial risk to an account.
Let’s deal with individual trade risk first. For every trade you place, you should have in mind a point where, if the market gets there, you decide that your view was wrong and take the loss on the chin. This is basic risk management: you do not want to hold on to losing trades forever and see your loss potentially get bigger and bigger and eventually wipe out the full value of your trading account, and more.
One of the simplest forms of risk management on a trade is placing a stop-loss order. For example, you place a buy trade in a chosen market at 100 because you think the price will go to 150. You then place a stop loss at, say, 85. This would be taking steps to manage the risk. You are accepting that the trade may not work out as planned and you are going to be disciplined and take the loss on the chin if the market drops.
Professional trading involves risk management and having a strategy for getting out if things do not go to plan is a fundamental part of this.
The other basic form of risk management is designed to help protect your trading account from a series of losses. Even the best approach will have a period of losing trades.
When many of us start trading, we trade far too big relative to the size of our account. Let’s say for example that someone has £1000 in a trading account and risks losing £500 on any one trade. If their stop loss gets hit, that £500 would be the loss realised. You do not need to be a maths professor to figure out that this approach to risk management is not really managing risk effectively. A couple of losing trades and bang – the account balance is down to zero.
Most sensible approaches to financial risk management when trading recommend risking just 1% to 3% of your trading account value on any one trading idea. This doesn’t mean setting your stop loss only 3% away, but it does mean that if a trade goes wrong and you are using the 3% approach, then only 3% of your trading account should be lost. That said, larger losses may occur where the price gaps through your stop loss level, for example due to a major news event.
Let's take the example above, buying at 100 with a stop loss at 85. Let’s assume our trader has £10,000 in an account and the risk management approach chosen is only to lose 3%. It means that if the trade gets stopped at your stop loss level of 85, only £300 should be lost. So if trading CFDs for example, the size to trade to factor in a £300 loss would be £20 per point (100 buy price – 85 stop level x £20 stake = £300 loss).
Traders with smaller account balances may need to be a little more flexible with their risk management approach, particularly when trading certain FX markets. This is because the FX markets can move in excess of 100 pips in any one day. In addition, 3% of a £500 account doesn’t allow a great deal of flexibility.
When setting profit and loss levels, for instance, one would need to use a slightly different risk-based approach, where risk is set relative to the potential profit you are looking to achieve. In this regard, for every pound of risk being taken, a trader may want to look for a return of at least double that in terms of the reward.
Many people ignore risk management and want to get "stuck in" straight away. But spending some time figuring out which risk management method suits your approach to trading should help you on the right path in the longer term.
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