What Is Trading Risk Management?
Every business is filled with potential risk. As a business person, stock trader, or even an organization, risk management is meant to be one of the top priorities. This is because failing to identify the potential risk you might encounter might end up wreaking you in the end. Most trading platforms in India recommend a certain per cent risk an investor can consider. So it is important to choose a good broker.
Risk management can be defined as the procedure taken before entering a business venture so as to curb losses. In trading, risk management refers to the steps taken by a stock trader in which he spots out, measures and analyzes the risk involved in trading before he accepts it or eliminates the risk.
Risk management can save a trader from losing all the money he has invested in the trade. At all levels, whether you are a beginner or an expert trader, it is important to have a risk management system put in place before venturing into the market. In this article, we will look at strategies and risk management tools to implement in order to build your risk management plan.
Risk Management Tools For Traders
Having a plan on how to manage your risk is important. Also, having the right tool to execute the mapped-out plan is equally essential. The trader suffers a lot when a risk is not well managed. But when managed, the trader will be in the right position to make more money.
The following are some risk management tools needed when trading,
The Trade Size
When trading, placing a reasonable trade size that matches the number of funds you can afford is the first step toward executing a great risk management strategy.
For example, let’s assume you have about $10,000 on your trading account and you wish to trade with it. You then open a leveraged trade that is worth $176,500.
Assuming the DJIA index, the margin required to open a trade is 5%. This means that for that trade, you must have 5% of $176,500 in your account excluding the trade cost. 5% of $176,500 is $8,825.
If you have $10,000 in your trading account and $8,825 is used as an initial deposit to open a position, then there is very little space for the trade to move before all your money will be used up and you will be liquidated. This is not a very smart move.
Let’s look at another instance. In this scenario, you have €10,000 in your trading account and you open a position on the CAC 40 index at €40,000. If a 5% margin is required to open a position, you will need €2,000 to open this position.
If you have €10,000 on your account and you are using €2,000 for that trade, you will be giving your trade enough allowance to grow and avoid losing all your money. Also, you will be able to place the desired stop loss on your account, rather than the trade bouncing you off the market because of the margin closeout policy.
The One Per Cent Rule
Many professional traders have over the years, followed a principle called the 1% rule. This means that at no course of their trading are they to exceed an investment of more than 1% of their capital in a trade. So assuming you have €50,000 in your trading account, you will be looking to risk at least €500 per trade.
Some traders can go with 2% if they can accommodate it. If you have an account with a higher balance, you can decide to go with a low per cent because the bigger your account, the wider the position. So take a small risk so as not to blow up your account in a trade.
Stop Loss And Take Profit Order
A stop loss order can be defined as the process of selling stock when the price is below the preset point and taking a loss on a trade. When a market price goes beyond the price you preselected, you will be bounced off the market while taking a loss from the trade.
For example, you open a buy trade on CHF/USD at $2.850. you set your stop loss at $2.650. if the price of CHF/USD goes below $2.2650, the trade will be closed automatically at that point or below and you will go with a loss of $0.2. This order serves as protection and a check for you not to lose more money.
Efficient ways of deciding a stop loss include using the support and resistance option, trade retracement or moving averages.
‘Take profit’ on the other hand will close a trade at profit. When a market is placed at long, the limit order will be positioned above the trade price. When you short a market, the limit price will be placed below the trade price.
Risk Reward Ratio
When trading, setting a reasonable risk and a reasonable reward is very important. Once you determine where to place your take profit and stop loss order, you must consider the ratio of risk to reward in that position.
Generally, most professional traders have made it a duty never to risk much of their capital. So they consider using a risk-reward ratio of 1:2 or 1:3. What this means is that the possible reward or profit from trade must be two times that expected risk or even three times the expected risk. This serves as a protection to the trader so that he doesn’t overtrade in the market.
Ideally, a trader must plan his trade carefully. If you don’t plan your trade, then you might be setting yourself up for failure.
Planning will also help you choose the right broker who can manage your trade. Some brokers charge very high commissions and fail to deliver the right services. They might even fail to offer good analysis for the active traders. Therefore, it is wise to choose the right broker when planning your risk management process.
When proper risk management is applied, then you might be on the right path to minimizing your losses and maximizing your gains. Utilize your stop loss and take profit order and develop discipline when trading.
