Trading is about risks and returns. Therefore, successful trading requires a sound trading plan, complete with a risk management strategy that helps avert massive losses.
Risk management is an essential aspect of your trading activities. Yet, regrettably, and despite the severe consequences, some traders disregard it. Consequently, we have put together the necessary information about risk management that will help you minimise and manage losses while trading.
Understanding Trading Risk Management
Incurring losses in your trade is hurtful. It is even more devastating if it is a loss that you could have averted. As an experienced trader, you might have always been on a winning spree, but unfortunately, it reaches a time that you incur losses. It can be catastrophic if you do not have a risk management strategy in place, as you might lose big time.
And how about when it happens to you as a beginner trader? You might be discouraged and even think of quitting trading. Risk management, therefore, is very crucial at whatever stage of trading.
Risk management strategies are the same irrespective of the financial product that you trade. For example, we have risk management in stock trading, risk management in forex trading, crypto trading risk management, among others. Therefore, it would be prudent to identify and understand the trading risks before you embark on managing them.
What Are the Trading Risks?
The common trading risks are as follow:
This risk results from the price volatility that in turn affects the entire market, hence bringing losses to your trade. For example, if you invest in an asset with the anticipation that the prices will rise and the opposite happens, you will end up making losses. The main factors that bring about the market risks are the stock prices, foreign exchange rates, commodity prices, and interest rates.
All trading assets have different levels of liquidity. Some assets like forex are more liquid compared to others. If you find yourself with an illiquid asset, you will incur losses as you will have no option but to sell it at a much lower price than you wished. It is occasioned by its low demand in the market, making it hard to find a buyer.
Trading in a leveraged asset means taking up more risks. The benefits of a leveraged product come with proportional risk. With a good trading strategy, you might make profits. Unfortunately, the darker side is that losing in such a trade translates to losing far more than the initial amount you deposited.
It is the possibility of losing all your initial trading investment without a chance of salvaging the amount. For example, on a long-term trading strategy, the value of an instrument might go up longer than you anticipated. Without funds to sustain the price until it plays in your favour, you will lose your initial investment.
Interest rate risk is the likelihood of a drop in the value of an asset resulting in an unexpected fluctuation in the interest rate. The risk is often associated with fixed income assets like bonds and not the direct equity investments like stocks and mutual funds.
Risk Management Strategies
Trading Risk management is the process of keeping losses under control and protecting your initial investment during trading. It involves identifying, minimising, and analysing risks.
In layman’s terms, it is a plan that helps you decide when and what to invest in and the trade’s point of entry and exit.
Below are examples of risk management strategies that come in handy to minimise risks associated with trading and help you to minimise potential losses.
The saying ‘every battle is won before it is fought‘ best explains this strategy. Please do not underestimate this step as it defines the outcome of the trade. We emphasise its importance by comparing it to training by athletes.
Irrespective of the type of asset you want to trade in, it is fundamental to have an in-depth understanding and knowledge of it and the risks involved. Failure can lead to straight losses that might lead you to exit the market quickly as you entered it.
Learning the trading process is also continuous — all expert traders can attest to this fact. It is because of the new risks, new trading techniques, and ideas that emerge every day. As a trader, learn and be at par with the dynamic market.
You can learn the trading process in several ways, most commonly through brokers. These brokers often also organise seminars, and from such forums, they teach about the types of risk management techniques. Make use of such to gain trading and risk management knowledge.
Another available option is trading articles and webinars offered on most brokers’ platforms.
Compare Risk with Return
Just as mentioned earlier, trading is a balance of risks and gains. The timing here is critical, and it is the thin line separating losses and gains. Compare your risks and returns and use them as a strategy to manage your risks.
Most often, the higher the risks or riskier the trade, the higher the returns. So, unfavourable study and analyse the market extensively and know when to strike. A correct move made at the right time means an increased chance of making profits.
Make Use of Stop-Loss Orders
A trader’s main objective is always to increase his chances of making profits. However, further losses can be prevented and managed using a stop-loss order, a risk management tool.
Using it provides a cushion from more losses occasioned by the unavoidable price fluctuations caused by the market’s volatility. With the stop-loss, you can pre-set the price by which your trade closes automatically, preventing you from further incurring losses.
It is, however, essential to take note of slippage. It is because slippage brings about price gaps in the market, failing to execute the stop loss.
If you have failed with stop-loss as a trader, consider adjusting the price until you find a favourable stop-loss level that will benefit you. Then, stick to it until you outgrow its usefulness and readjust again.
Make Use of a Take Profit
A take-profit order is similar in principle but opposite in application to a stop-loss order. It is a short-term trading strategy that specifies the exact price you would want to close a position and lock on the profit. A trading strategy such as day trading can be used with the take-profit order.
Be well conversant with your trade before applying a take-profit order by doing exhaustive market research to maximise this risk management strategy. This way, you will know where to use the take profit order. Most traders, however, find it safe setting their rewards at twice the risk of the trade.
You can easily make losses with this risk management strategy if you make a speculation mistake. Therefore, it is advisable to weigh the loss against the profits you are likely to make when applying this risk management tip.
Risk What You Can Afford to Lose
The temptation of investing vast amounts of money with the anticipation of making huge returns happens to be an irresistible charm, especially to novice traders. However, do not invest funds that, if you lose, will affect you in the long run.
The losses you incur can leave you emotionally and financially unstable, rendering you unable to explore more trading options. Therefore, we urge you to make it a habit of evaluating the trading risks before investing. If your gut feeling is that there is no potential to make a profit, don’t invest.
In addition, it is advisable to wait until a better opportunity arises, but if you cannot wait, then reduce your investment. In short, invest funds that will not adversely affect your trading even if they are lost.
Use Leverage Wisely
Trading with leverage can be used to make some good profits. It is because you have an opportunity to trade using borrowed funds since you trade with much more than your capital investment.
Unfortunately, as mentioned earlier, it comes with a proportional magnitude of risks. If your trade does not go according to your speculation, then it means that you end up losing money. Money that was in the first place not yours and unfortunately you must pay.
It is advisable not to go for leverage because of the risks that come with it unless you are sure of your trade through the market analysis.
Apply Technical Analysis
When starting a trade, it is vital to know the entry and exit points. You can use technical analysis for support, and resistance levels will aid you in identifying these points. Use trend lines to find accurate support and resistance levels and combine them with the stop-loss and take-profit risk management strategies.
The Relative Strength Index (RSI) momentum indicator measures the level of price changes that produce overbought and oversold conditions of an asset price. The RSI can be used together with support and resistance levels.
Diversify Your Portfolio
You can manage your risks by diversifying your portfolio. The key benefit of this strategy is minimising your risk of loss. For example, suppose one investment performs poorly over some time. In that case, you have a cushion from potential loss as the other investments may perform well over that same period.
It would not be the case if you invested all your capital on one asset. Simply put, the investments will cover for each other when one goes against expectations, and the other exceeds expectations so that the net effect is a profit.
Hedging is a strategy that you can use to minimise losses by taking an opposite position in a related asset. For example, if you hedge against market price to attain a price lock, you protect yourself from unfavourable price movements.
Using derivatives like futures contracts and options is one advantage of hedging. It will allow you to trade at a particular time within a specified period.
Start with Demo accounts
Demo accounts are platforms offered by brokers as a way to train novice traders. They are free-for-use accounts where you practice trading using virtual funds instead of using real cash.
Make use of these Demo accounts to know what is trading and risk management before going live.
Elements of Successful Trading Strategy
The primary objective of a trading strategy is to keep your eyes locked on your trading objective and identifying what are the types of risk management. It enables you to shift your attention from worrying about losses to concentrating on increasing your winning chances.
A good trading strategy should have the following elements, which are an essential aspect of every trade.
- Money management
The primary rule of money management is to invest money that you can afford to lose. Never trade with money meant for your basic needs.
Good money management prevents you from taking huge risks with your trade hence reducing potential dangers that came from such a risk. Also, know about managing your trading funds.
Have a clear trading plan before starting a trade. It should include the asset to trade in and have straightforward entry and exit plans.
While trading, do not be driven by emotions. Fear, excitement, and greed will divert your attention from your trading plan, which can have devastating effects. Set new goals and improve your trading strategy for the following trading activities by factoring in experiences from your past trade.
- Trading Tools
Set up all the equipment that you will use for your trading before starting up a trade. Lack of reliable trading tools will contribute significantly to your losses. Have stable and reliable internet, a desktop, and a mobile phone to enable you to monitor your trade even when you are out of your workstation.
Every trader, expert or beginner, should have a trading risk management strategy at the core of their trading plan. When the expertise level rises, the trader will understand how much they can risk as they minimise losses and maximise their chances of making profits.
Market analysis is critical in risk management since it lets you know when to enter and exit a trade. However, you will never avoid losses in a trade. The only way is to learn how to manage them. As a beginner, it is imperative to learn how to minimise severe losses. Therefore, use the above strategies for an enjoyable trading experience.
Exercise caution and moderation when starting trading until you attain a full grasp. Also, take advantage of the free demo accounts from brokers to practice or test yourself adequately before opening a live trading account.