Top 5 Risk Management Techniques Every Trader Should Know
Traders speculate the price movements of currencies, commodities, precious metals, indices or cryptocurrencies to take advantage of market volatility. While some trade these assets directly, others gain exposure to them via derivatives like CFDs (contracts for difference). While volatility presents the most attractive trading opportunities, it also spells the most risk. And no matter how good your technical analysis and trading strategy, the financial markets can be highly unpredictable. This is where a good risk management plan comes into play. It is essential for all traders, novice and professionals. More so for traders who use high leverage.
So, what does risk management entail? This article describes the risk management process and the most popular strategies to manage risk.
What is Risk Management?
The risk management process has four major activities: identify, measure, analyse, and mitigate risk. The goal is to cut losses in case the market moves against your predictions.
Market risk is systematic, which means that, with every position a trader takes, there is an opportunity to manage the associated risk. More importantly, it is the use of good risk management strategies that can make or break a trading portfolio.
Before You Begin, Let’s Learn the Basics
Traders must invest time in understanding fundamental risk calculations, such as risk-to-reward ratio, hit rate, and risk of ruin. These help them to apply risk management strategies appropriately.
Risk to Reward RatioThis is the most important metric associated with each trade and it is fairly self-explanatory. Is the risk worth the potential reward. Risk to Reward Ratio = Potential Loss / Potential Profit
Hit RateThe hit rate depends on the trading strategy and the instrument. The number of possibly successful trades is estimated when making the trading plan, and the best practise is to over-evaluate the possibility of going wrong. It ranges between 0 and 1, where 1 is always having successful trades. Hit Rate = Number of Profitable Trades / Total Trades
Strategy durability means the accuracy of the trading strategy. Traders use demo account reports to calculate the accuracy of their chosen strategy. Generally, if the hit rate is 0.5, your strategy will be about 40% to 60% accurate.
Risk of Ruin
Risk of ruin is a metric that considers the overall payoff ratio, percentage accuracy, and percentage risk per trade. This one statistic reveals the chances of a trader ruining the account or making profits and take positions accordingly.
Here is an example of risk of ruin calculations:
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Top 5 Risk Management Strategies
Even the best risk management strategy will not eliminate risk completely. You will need to take a certain amount of risk to make gains in the financial markets. The idea is to always be aware of how much risk you are taking and whether that justifies the profit potential from a trade.
1. Determine Your Risk Exposure
Risk is inherent in every trade. Therefore, traders must determine their risk exposure upfront. For instance, a common strategy is to not risk more than 1% of your account on a position and 5% across all open positions. However, the risk is subjective. A trader trading with a margin may prefer to reduce their risk exposure even further.
This strategy helps protect the account even when the trader is on a losing streak. Additionally, it allows them to take advantage of new trading opportunities as there is always some margin that is not tied to existing open positions.
2. Trade with Stop Loss and Limit Orders
Place stop loss and limit orders with every trade. This allows you to check the exit points with your trading plan before opening a position. These checkpoints help you get out early in the event the market moves against your speculation. You may consider placing guaranteed stops if the market is highly volatile. This closes the position even if there are price gaps at the stop loss price point. Using stop loss and limit orders as a risk management technique has threefold benefits:
- Your downside is protected.
- You can stop staring at the screen and making decisions in the spur of the moment.
- Your trading remains based on your trading strategy, rather than being driven by emotions when the market is moving against you.
Did you know?
Seasoned traders use trailing stop loss to protect their profits when the market moves as per their expectations.
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3. Take Intermediate Profits
Taking profit is as important as stop loss. After all, that is the main goal of trading. Traders often open positions and keep adding capital if the market moves favourably. But they tend to forget that the market can stop trending and suddenly reverse its direction, which may result in lower profits or even losses. Take profit orders can prevent winning trades from turning into losing trades. It is better to take some profit before that happens. This risk management strategy ensures that even if the market crashes for any reason, the traders gets out with some profits.Did you know?
Experienced traders often use a two-lot system, in which they close half of their positions once the profit target is reached. This prevents accumulating a greater loss if the market reverses and a stop loss gets triggered.
4. Diversify Your Portfolio
Diversifying your portfolio with instruments that have low correlation can contribute significantly to the overall portfolio performance remaining stable. With highly correlated instruments, the risk is amplified. This is good only until the market moves favourably and is a problem as soon as it goes against your speculation.
5. Build a Strong Trading Mindset
Trading psychology is key to a trader's actions. While trading is an analytical activity, traders often fall prey to emotions like fear, greed, revenge, or overconfidence, since money is involved with every decision made. Live markets can be fast-paced and unforgiving, and preparing well is an important risk management technique that can save traders a lot of trouble. A strong mindset can be built by practising on a demo account and recognising events or triggers that force cause you to act against your trading plan. This helps build a conscious self-check attitude when implementing a trading plan.
To Sum Up
- Risk management helps cut losses in uncertain financial markets.
- Risk management needs to be part of the core strategy and not an afterthought.
- Learn the basic risk calculations to evaluate your exposure.
- Use stop loss and limit orders to protect your downside.
- Take profit orders help book returns when the market moves favourably.
- Build a strong mindset to prevent emotional overtrading.
- Diversify into uncorrelated markets.
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