Best Risk Management Tips for Trading

Risk management while trading is the procedure followed to identify, evaluate and mitigate potential losses that could be involved in an investment. For a trader, the risk of loss arises when the market suddenly moves in the opposite direction to their expectations. The fact is that market trends do change abruptly due to various reasons. Some of the most common events that cause market volatility are:

• Political events, like elections
• Economic events, like central bank interest rate decisions
• Business events, like new product launches.

Being aware of such events is only part of the process. To manage risks, you also need to understand:

• How much money can you afford to lose on each trade?
• What is the risk/reward ratio of the trade?
• Does your trading strategy include steps to limit risks based on your risk appetite?

There are strategies, procedures and rules that can help minimise financial risk so that you need not face risks greater than what you can bear.

Importance of Risk Management for Traders

Successful traders never enter a trade without having put risk management measures in place. Their trading strategies include actions that minimise risk. One saying about trading strategies that highlights this is, “Try and increase the controllable and reduce the uncontrollable.” This essentially means that you should have enough knowledge of the markets and assets you are trading to be able to predict the future outcome of your trade as accurately as possible and have measures in place for the possibility that the prediction does not pan out due to uncontrollable or unpredictable circumstances.

For instance, you might have checked all the news about inflation, expectations regarding the ECB’s interest rate hike plan and the economic outlook for the EU, and then chosen to go long on the EUR. But then Russia attacks Ukraine and the world imposes sanctions, which leads to oil and food shortages across Europe. This then impacts the performance of the EUR. Now, if your trading strategy did not account for the possibility of the EUR’s value depreciating and you entered into a leveraged trade, it could even wipe out the entire capital in your trading account in the worst-case scenario.

Now that we’ve scared you enough about the need for risk management strategies, here’s a look at how to manage risks.

How to Identify Financial Risks

To manage risks, you need to first identify them and their sources. This requires knowledge of the variables that are in play at the time. Identification of financial risks while trading can depend on:

• Primary economic factors, such as interest rate decisions and trade wars. Such factors can impact the all markets, across assets and industries.
• Secondary economic factors, such as the economic reports that impact short- or medium-term trends because they affect investor and consumer sentiment, e.g. unemployment data.
• Tertiary economic factors, such as the quarterly earnings reports of companies, don’t just affect a specific stock but could also impact the index the stock is listed on.

After analysing the factors that could affect your portfolio, follow the below steps to identify how much risk might be involved:

• Identify which economic event can affect the assets you are trading.
• Note down their characteristics, in terms of the power to influence prices.
• Write down the factors that could affect the data.
• Eliminate the market noise and focus on the relevant news.
• Describe the probable scenarios.
• Understand whether the factors will have a beneficial or adverse effect on your investment.
• Brace for any unpredictable scenario your portfolio might face.

While making a trading decision, always ensure that you are considering all the factors that could affect your portfolio or assets. Make an escape plan and work accordingly.

Risk Management Strategies

A well-researched and tested strategy can increase your chances of staying in the market for a longer time, with lesser losses. Below are a few measures that can help you reduce risks while trading.

Trade with Money You Don’t Need

The first and foremost rule is to only risk the amount of money you can afford to lose. Many beginners might be overconfident of their chances of earning a profit and skip this most important rule. A general rule is to not risk more than 1% of your trading capital on a single trade.

Educate Yourself

As Benjamin Franklin famously said, “By failing to prepare, you are preparing to fail.” So, before you start your trading journey, learn about the financial markets, what moves them, and the risks involved. Successful traders often say, “Plan the trade and trade the plan.” In fact, experienced traders continue to educate themselves throughout their trading lifecycle.

So, make sure you do your homework. If you are in it for the long term, make sure you learn about:

• Macroeconomic factors and how they influence the markets
• How the sector in which you are investing functions, and what moves it
• The specifics of the asset you are trading.

You also need to stay informed of certain aspects, especially if you take short-term positions, such as:

• Study the news flow
• Study the technical charts
• Understand support and resistance levels

Without proper education and knowledge of these things, you won’t be able to go too far in the world of trading.

Stick to Your Plan

Discipline while trading is among the most important factors responsible for managing your financial risks. The market is quite ruthless and unforgiving. It doesn’t spare even the best traders and punishes them for the slightest mistakes. Whether you are a short- or long-term investor, discipline should be the cornerstone of your investment strategy. Stick to the rules you’ve set and your trading plan, irrespective of the circumstances.

Position Sizing

Position sizing is the ratio of a single position size to the total capital. Successful traders use the 1% or 2% rule while trading. This means that the maximum amount of risk they consider feasible for a single trade is 1% or 2% of the capital in their trading account. This helps avoid the temptation to take on excessive risks while chasing gains.

For example, if you have $1,000 in your trading account. A single trade should not cost you more than $10, if you follow the 1% rule. The remaining amount should serve as a buffer for other investments. So, adjust your position size accordingly.

Study of Liquidity

High liquidity means that there are enough buyers and sellers at the current prices to ensure fast trade execution. Apart from choosing a broker that assures deep liquidity, you also need to check market conditions. This is because liquidity tends to be higher for some asset classes than others, while also being higher for some securities within an asset class than others. For instance, the EURUSD is the most popularly traded forex pair and tends to see much higher liquidity than minor or exotic currency pairs.

Also, remember that liquidity might differ for the same asset based on market conditions.

Understand Leverage in Trading

Leverage trading, as the name suggests, is trading with borrowed capital. In leveraged trading, you use money borrowed from your broker, such that you only fund a fraction of the total cost of the trade, with the broker funding the rest. For example, if the trade costs $1,000 and you use a leverage ratio of 100:1, you only need to fund $10 and the broker will provide the remaining $90.

Leverage is popular because it allows traders to gain much larger exposure than they can afford to with just the capital in their trading accounts. However, leverage is often referred to as a “double-edged sword,” since it multiplies your profit potential but also magnifies potential losses.

So, use leverage wisely. Understand the loss potential before choosing the leverage ratio.

Use Stop Loss and Take Profit Orders

Knowing when to exit the market is as important as knowing when to enter it. Determining your exit is possibly one of the best risk management strategies. There are three types of orders that help with pre-determining the exit point.

1. Stop Loss: This type of order helps limit the loss you incur on a trade by setting a price point at which your trade will be closed. This is done at the time of entering a trade. With a stop loss order in place, even if the market suddenly reverses and you don’t realise it, your position will be closed at a pre-determined level, before losses accumulate.

• Take Profit: This is also a type of order that should accompany every trade. Here, you set a price point above the entry point, at which your position will be closed. When the market is moving in your favour, it is easy to be tempted to hold on to a position. But often, the trend suddenly reverses, and a winning position can turn into a losing one. With a take profit order, you can lock in the profit before such a reversal.

• Trailing Stops: This is a variation of the stop loss order, where the stop loss moves while the market moves in your favour. Similar to a stop loss, the position is automatically closed when the price direction changes.

General Risk Mitigation

Apart from considering the risks involved in a specific trade, there are some measures you can take to protect your overall portfolio.

Control Your Emotions

Letting emotions rule your decision-making isn’t recommended for any profession, and trading is no different. The two major emotions that can overwhelm a trader are fear and greed. Fear can lead you to exit a position too early, while greed can tempt you to overtrade. In either case, the risk of losses increases. Experienced traders recommend keeping a trading journal, where you can note down all the factors affecting you and your trading decisions. Going through the journal can help you identify unhelpful patterns, including emotions, which you can then work to overcome.

Another way to steer clear of emotions is to base your decisions on robust research and your trading plan and avoid making spontaneous choices.

Diversify Your Portfolio

Successful traders never put all their eggs in one basket. This means not only trading multiple (preferably uncorrelated) securities from a single asset class but also trading more than one asset class. This way, the underperformance of one asset is compensated for, or at least the impact is minimised, by the outperformance of another.

Hedging Your Trades

Hedging refers to an investment strategy where you open two disparate trading positions in a single asset. For example, if you are trading the EUR/USD, you can choose to go long on one currency and short on the other in the pair. Here, if you suffer a loss in your primary position, your secondary position could make up for it.

Monitor Your Trades

Just placing a trade isn’t enough. You need to keep an eye on it. However, not everyone has the time to constantly monitor the markets and their trades. This is where algorithmic trading or Expert Advisors come to the rescue. You can automate your trades by setting parametres for opening and closing positions. The trading platform then does the rest. Of course, it is useful to keep a check on the EAs you use and fine-tune the parametres, based on your trading experiences and research.

Test before Trading

Whenever you plan a trading strategy, it is useful to first test it on a demo account before risking money on it. This way, you can tweak the strategy to ensure that it works well in live market conditions.

A Final Word

Remember, even the most successful traders face losses. So, don’t get disheartened when trades don’t turn out the way you expected them to. Learn from mistakes to become a stronger trader. You know what they say about getting back up on the horse! Plus, with the right risk management strategies in place, you can actually increase your chances of long-term success in the financial markets.

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