Ask many first-time traders and they will tell you how making profits was what drove them to trade. Yet few will talk about Risk management which should the first thought to enter any aspiring trader’s mind! It might sound counter-intuitive, but a trader’s priority is not to lose money – making profits comes second. In this article we will show how risk management techniques can insure you enter successful trades rather than losing money.
Risk management can be achieved though a variety of ways such as understanding where the risk originates from (yourself) and knowing how to take a risk whilst limiting the chances and scale of a potential loss. There are several risk management techniques which we highlight and explain in this article.
Knowing your personal risk tolerance is something that many new traders have rarely thought of. Knowing what is the maximum exposure that you can tolerate should be your first aim. Such self-knowledge is a hallmark of any successful trader. So start off small: only risking 1% of your portfolio, so if you have a £1,000 portfolio, that would mean a £10 position, £10,000 portfolio would mean £100! Determining the maximum amount of money that you can tolerate losing per trade will also develop the emotional trading discipline needed to know when to cut your losses. Not every trade is successful!
Another risk management tool is using ‘stops’. Managing every trade carefully requires always using a protective stop. It’s often an idea to avoid placing a stop on a round number such as 100 / 2,000 / 750 as there are often concentrations of orders at these levels. For example it’s best to place a stop at 98 / 1994 / 747 (using the levels above). Market volatility is part and parcels of trading and being prepared for a freak market event which goes against you is part of good risk management, something stops can mitigate.
Risk management through knowing your risk tolerance and placing stops are useful but understanding your trading style is important. How can you stop yourself from making the same mistake repetitively if you don’t know what you style is? Some traders will trade several times in day, others will be focused on trading over a few days/ a week etc. You can also be driven by momentum, price action or volatility. Whichever is your fancy, knowing your trading style means that if the market is not primed for your style you can sit it out.
Sometimes good risk management is knowing your own limitations.
Although not necessarily a risk management strategy, limiting over-trading will help. Lack of patience can be a real problem for traders. It can lead to you trading because of a desire to trade rather than a genuine opportunity. This can also lead to successful trades being closed early because of the traders’ need to be doing something and gaining the satisfaction of a small profit. Every time you trade, you are creating a risk. By only trading when you see an opportunity which meets the parameters of your trading strategy you are reducing your chance of a loss whilst increasing the likelihood of a successful trade. If you do find that you are trading a lot and being unsuccessful, it may be a good idea to stop trading for the day and go to the pub! Coming back with a clearer and chilled out mind will put you in the best position to spot an opportunity. Furthermore, learning to preserve your capital should be a priority for any trader, without capital a trader cannot trade!
Psychology may not sound like a risk management technique, but it plays a part in leading us to trade. Trades should only be created if these meet the disciplined trading strategy you have already set out. Emotions such as greed and fear can lead to traders taking decisions they would otherwise not have taken. Traders need to know how to handle both emotions to their advantage: as Warren Buffet once said one should be ‘fearful when others are greedy and greedy when others are fearful’. Aspiring traders should realise that Risk management works both ways. Controlling your emotions to cut losing trades early and learning to be greedy and letting your successful trade run its course is important for any trader. Without risk there cannot be a profit!
No one said that Trading is easy! Markets are continuously moving to news that we don’t know about. Good analysis, a disciplined strategy, good execution and above all good risk management are indispensable. Those who prioritise risk management over profits will soon realise that the former does not stop the latter!
Knowing your personal limits, how to use stops, how you trade and how your emotions effect your trading will allow to manage your exposure to risk. This ensures that if a trade does not go the way you wanted, you are able to minimise your losses.
Understanding the relationship between risk and reward will help. No trader cannot afford to take no risk, as there would be no reward, but working out how risky an opportunity is will help form a decision whether this trade is worth it. Risk management is not there to stop you from trading but is there to help you take a risk whilst limiting any potential downside! Embracing risk management may just make you bigger profits!