It’s no secret that the best traders incorporate risk management into their trading strategies to cut down their losses. The concept of mitigating risk is talked about often in the trading world but what exactly is risk management?
Defining risk management
In the trading sphere, risk management is the practice of identifying, analysing, and minimising the downside of transactions in advance. Risk management sustains profitability and minimises the impact of unexpected volatilities. There are various ways to limit risk exposure, but the basis of risk management is made up of three basic, yet extremely useful, actions.
- Sticking to a comprehensive trading plan
Without a strategic trading plan, it’s very easy to get lost in the fast-paced markets. A robust plan helps a trader to:
- Identify the products that offer optimal volatility and liquidity levels.
- Trade consistently and increase the chances of achieving replicable results.
- Formulate money management parameters. For example, many traders use the 1% rule which suggests that no more than 1% of capital should be put into a single trade.
- Create effective leverage guidelines and adhere to an optimal percentage that ensures adequate risk control e.g. 3%. Increasing the degree of leverage increases a trade’s risk exponentially.
A comprehensive trading plan also reduces bad habits such as reckless money management and overtrading.
- 2. Setting protective stops and profit targets
Protective stops (also known as stop-loss positions) and profit targets are integral components of risk management. When used with a robust trading plan, these two order types reduce risk and help protect profits.
A protective stop is an order that’s placed in the opposite direction of an open position. When the price reverses to the location of the protective stop, the open position is automatically closed-out or liquidated, thereby limiting losses before they escalate.
A profit target locks in gains that are realised from beneficial price movements and it works similar to protective stops.
Stop-loss and Profit Target Takeaway: Profit targets and stop-losses play a key role in risk management. While the stop-loss reduces a trade’s ultimate downside, the profit target helps to ensure profits are realised and not lost in the wake of negative price action.
- 3. Creating the optimal trade-off between risk and reward
A trader needs a risk-reward balance to get financial gains without exposing their capital to excessive risk. A risk vs reward ratio can be used to determine the potential risk exposure and return attached to a specific trade.
For example, if you put in $500 to buy an investment at $25, you get 20 units of the investment. With a profit target of $30 per unit, you will potentially make $5 for each of your 20 units for a total profit of $100. Your risk/reward ratio will be 500/100 or 1:0.2.
But traders ideally limit risk with stop losses. If you set a stop loss at $20 and leave the profit target at $30, you risk $5 ($25-$20) for a potential profit of $5 ($30-$25). Your risk/reward ratio will be 1:1.
If you raise the stop loss to $23 and maintain the profit target, you risk $2 for a potential profit of $5 and your risk/reward ratio is 1:2.5.
Trading tip: A minimal 1:1 ratio is prudent. However, the risk/reward ratio should be combined with the winning percentage for more robust risk management.
A trader with a high winning percentage can still be profitable with a lower risk/reward ratio. For example, a trader who risks $400 on a trade for an $800 profit target has a positive risk/reward ratio of 1:2. However, if her winning percentage is 30%, she makes a loss of $400 for every 10 trades.
On the other hand, a trader who risks $400 for a $200 profit target has a negative risk-reward ratio, but if her winning percentage is 70%, she realises a profit of $200 for every 10 trades.
The importance of risk management
You can’t control market movements, and trying to do this will only result in untimely capital loss. Sound knowledge in constructing trades with strategic and objective risk management is key to staying in the trading game. Which risk management technique has worked for you? Join the conversation and share your thoughts.