Managing your risk

  • Managing risk is one of the most important aspects of successful trading. It’s impossible for traders to know exactly how a price will move at any given time.

    But, what you can do is take full advantage of the times when you’re right, and attempt to minimise risk as much as possible for the times when you’re wrong.

    A goal is to target longevity when trading so that your account will survive to trade another day.

    There are three main things to keep in mind when you’re planning your risk management and we’ll look at each of them in turn:

    • Stop losses (mental versus hard)
    • Position sizing
    • Reward/risk ratios

    Stop Losses

    a) Hard stop loss

    A stop loss is designed to do exactly what the term suggests; it takes you out of a trading position at a certain pre-determined point when the position has a negative value. The most common form of stop-loss is the “hard” stop loss, where the trading platform is pre-configured to close a position at a specific price level where the position would show a loss.

    Using hard stop losses is an extremely important aspect of risk management as it allows you to clearly define your risk for every trade. Stop losses should be placed according to market conditions and should strike a balance between being too close to the market price and too far.

    Stop losses can also be moved during the course of an open trade in order to lock-in or break even on any profits that may have been made.

    However, stop losses should only be moved in the direction of the trade, and not in the opposite direction. Moving stop losses in the opposite direction of a trade can potentially leave you with substantially larger losses.

    b) Mental stop loss

    Another kind of stop loss is called a ‘mental’ stop loss. It’s not really a stop loss at all. It simply consists of a trader telling themself that a position should be manually closed at a certain point of pain. If the trader lacks the discipline to act upon a mental stop loss, however, trading losses could potentially grow very quickly on a losing trade.

    Mental stop losses only work if you have enough discipline to close your losing position when the predetermined price is reached, which can be tough for even the most experienced traders.

    Position sizing

    Besides the use of hard stop losses, trade positions should also be sized prudently. The amount of market points risked - as defined by a position’s stop loss - combined with the size of the position, dictates the actual financial risk you’re taking on that position.

    Generally, risk on any single trade should not exceed a maximum of 5-10% of the trading account’s total equity. Professional traders may risk significantly less than 10% on each trade.

    Reward/risk ratio

    The reward/risk ratio is another important thing to think about in your risk-management.

    Reward/risk ratios vary according to the type of trading strategy you use as well as the particular market traded.

    In general, however, it’s not a good idea to have a ratio below 1:1, because the risk outweighs the potential reward. If this is the case, then the number of winning trades must exceed the number of losing trades in order for you to achieve net profitability.

    On the other hand, the more that potential reward outweighs risk, the fewer winning trades you’ll need in order to achieve net profitability.

    There are successful traders that have a low win percentage but are still profitable due to their high reward/risk ratio. At the same time, it should be kept in mind that traders with higher reward/risk ratios generally have lower win percentages, while traders with lower reward/risk ratios generally have higher win ratios (if all other variables are the same).

    So, to recap, these five risk-management techniques should be part of your risk-management strategy:

    1. Use hard stop losses instead of mental stop losses, especially if you lack the discipline to act on your mental stop loss.

    2. Do not allow the monetary risk on any one trade to exceed a maximum of 10% of your total account equity.

    3. Look at moving your stop losses in the direction of an open trade in order to lock-in any potential profits.

    4. Target a reward/risk ratio greater than 1:1 so your potential reward exceeds the risk on each trade.

    5. Diversify your risk exposure by trading non-correlated markets, i.e. markets whose price movements are not related or not impacted by the same events.

    Risk-management orders

    Learn how to use risk-management orders to help limit losses