What is risk management
What is risk management? It’s exactly what it says on the tin: managing your risk – or the amount of risk you apply to each trade you place… so that you can cut your losses early and let your winners run to the stars.
It is the one thing that will set you head and shoulders above from the majority of ‘have-a-go-heroes’ in an industry where 92% of participants are ultimately doomed to failure.
If you have your hopes set on joining the winning elite by making consistent profits from trading in any market, employing effective risk management is a great start.
But the good news is that it is neither complex nor tedious.
It is straight forward and the only bit of maths you really have to do in trading. The following rules will give you a lucid insight into how to use risk management to enjoy long-term prosperity in the financial markets by keeping losses to the minimum and profits, maximised.
What is risk management: Keep the risk low
Ever heard the old adage in investing: “never risk more than you can afford to lose”? Trading the forex market – or any financial market for that matter – is no exception to the rule. Never risk more than 1% of your account’s value per trade when placing the order, no matter how good the set-up looks.
So if you have a $1000 account, you risk no more than $10 per trade (risking a conservative yet wise 1%). If you have a $10,000 account, you risk no more than $100 per trade. If you have a $50, 000 per trade, you risk no more than $500 per trade. One per cent is one percent – nothing more, nothing less.
Never, ever risk more than 1% of any trade unless you have has 3 months consistency under your belt. By that time, you can scale up to risking 2% per trade. However, it is strongly unadvisable to risk more than 1% until you reach this level.
Failure to keep the risk low in trading will have dire consequence and it is one of the main reasons why many amateurs simply wipe out their account, choke on their corn flakes, kick the cat and….give up.
Markets are random. They are chaotic mess and can do anything at any time. Great looking tradable opportunities can sometimes crash and burn at the turn of a dime. So by risking only 1% per trade you are able to accept that the worst possible thing that could happen to you if the trade goes against you is that we lose 1% of your account…which is a damn side better blowing the whole account.
What is risk management: Always use a stop loss
For every trade you place with your broker, you should always apply a protective stop-loss to it so that if the market does move against your trade (remember, markets can do anything at any time), you can automatically exit the market without taking an unnecessary hit.
Gone are the days of feverishly watching the screen wondering whether you should exit or not in the heat of the moment. The great thing about a stop loss is that it that your broker will automatically exit you from the trade if the market does move against you…providing you place the stop-loss order in the first place.
While brokers have a vested interest in you entering the market, they do not have a duty of care towards you when trading the markets – your losses, after all, are their wins, and in most cases, they will not make using a stop-loss a mandatory requirement. The onus is on you to do make sure the stop-loss order is placed.
A stop-loss should be placed at a point where if price goes against you and it hits it, then the original set-up is then completely invalid.
You should get into the habit of placing the order for a mandatory stop-loss for every trade you place as there is nothing more emotionally jarring than diving straight into the market without a stop-loss and telling yourself that you will manually exit if price reaches a certain point against you. Often, doing this will cause you to move the goal posts and deviate from the original plan, which is a big no no (this is where many traders lose more than what they bargained for!).
What is risk management: Make high reward trades a must
Ever found yourself trading your chosen trading strategy just because you have your trade set-up? That’s good enough. Face it, most amateur traders don’t bother to even do this.
However, it will be worth your while question how much profit potential you have from the trade and to only trade the set-up if a minimum reward threshold has been met.
You will almost certainly trade less, but the quality will be higher.
If, say, you have a difference of 45 pips difference between your entry point and stop-loss but a profit potential of 243 pips difference between your entry point and your profit target, then you have a reward/risk profile of 5.4:1. So if the trade goes on to hit your profit target, the best thing can happen is that you make a 5.4% gain on your trading account. However, if the trade goes against you then you know that, as you have only risked 1%, the worst possible thing that can happen is that you lose 1%.
In very much the same way that your trading strategy has a set of rules for entry with each rule or requirement acting as a ‘filter’ preventing you from ultimately getting you into a bad trade, the requirement of a minimum reward/risk profile is a useful addition.
Face it, we have all been there. Why bother trading a higher frequency of trades with smaller profit potential than less trades with higher profit potential? Many traders, particularly those who are new to trading, find it hard to stay out of the market and unwittingly trade a high frequency of trades with for tiny reward at their peril.
But if you adopt the simple rule that you will not place a trade unless you have a potential reward/risk profile of 3:1, you will find yourself trading less but in higher quality trade set-ups.
The great news about high reward to risk trading is that you can afford to have more losing trades than winning trades and enjoy an overall percentage gain. Say, for example, you placed ten trades each risking 1% and went on to incur seven losses, losing you a combined total of 7%. Compared this to the three winning trades which went onto make 3% each (9% in total)…you have an overall profit of 3%.
That’s the power of positive reward/risk!
Conclusion – What is risk management?
Is trading forex a risky business? It does not have to be providing you follow the rules for effective risk management.
Risk management is systematic, helps take the emotions out of trading and cuts losses fast while letting your winning trades run.
From using a stop loss you will be able to automatically exit any trade which goes against you without being glued to the screen. By keeping your risk per trade to 1% of your trading account, you will never run the risk of blowing up your account – or taking an unnecessary hit. Lastly, by only selecting trades with a minimum reward/risk profile of 3:1, you will be able to potentially make more from trading less.
By doing this, you will leave the thrill seeking to the feckless gambling types and will have turbo-charged your chances for long-term success in trading.