Trading is a game of high rewards and equally high risks. And though it is impossible to win every single trade, it is important to keep your invested funds under control.
So, being able to apply risk management strategies correctly can make sure a trader doesn’t lose their entire deposit on one trade.
In this guide, we will take a look at the ways to maximize your potential gains and also minimize your potential losses using risk management techniques for trading, but first let’s find out why risk management is so important for every trader. And if you’re new to trading, consider trying out the currency converter, which is a quick and effortless way to instantly convert multiple currencies all in one place and choose the free trading platform, for example, Metatrader 4, where you can start your trading career.
What Is Risk Management?
Overall, trading risk management is a strategy that is used to minimize possible losses and protect a trader’s assets. It is one of the central pillars to the trading business, alongside strategy and psychology. So, even if you have found the best strategy possible and adopted a solid psychology, without an effective risk management system your losses might start to expand.
Basically, being a viewpoint that concerns everything that can possibly go wrong while trading, risk management, however, doesn’t consider only losses. It also defines the reasonable profit target a trader aims at without worryingabout the stability of their portfolio.
Identifying Trading Risks
Risks that are commonly associated with trading include slippage risk, gap risk, and poor execution risk.
Hidden costs that follow transactions are the focus of the slippage risk factor. Every time a trader enters or exits a position, their account balance tends to dwindle a bit. That means every time a trader executes a trade, they become a subject to the problem of making a purchase at the ask price but selling at the bid price, which is always lower than the ask price. As a result, the amounts for the trades may seem small at first, but as a user’s trading volume increases, so do the amounts they lose.
Gap risk is associated with a break in trading. For example, a stock closes at $25 a share today and opens tomorrow morning at $20, meaning that if an exit price you planned is $24, and you have a stop order in place, your order is likely to be filled at the opening price or worse. Often price gaps created in this process occur most at the open. Although relatively rare, a gap also may occur whenever trading halts or any surprising news is reported.
Poor execution risk arises when a trader or a broker encounters problems in making an investment or a trade. This problem usually occurs whenever a broker has a difficult time filling a trader’s order, which results from any factor, such as fast market conditions, absence of buyers/sellers, and poor availability of stock.
Consequently, the expected price differs from the price a trader actually receives. Although this risk can be mitigated to a degree, for example, by using limit orders, you still risk ending up with a stock trade through your limit price and your order not getting filled at all.
Risks Evaluation
The trading risk evaluation implies defining the performance of a portfolio in the stock market. The two ways to evaluate the market risk are called Alpha and Beta.
Alpha is used to estimate an investment’s performance compared to a certain benchmark index. For instance, a positive alpha of 1 means the fund has surpassed its benchmark index by 1% while a negative alpha of -1 means the investment underachieved by 1%. An alpha of 0 indicates that the portfolio is following the benchmark perfectly.
Beta measures the volatility of a portfolio compared to the market in total. Generally, a beta higher than 1% indicates that the portfolio is more volatile than the market. Conversely, a beta of -1% points out that the investment is less volatile.
Low beta stocks are alternatively called defensive stocks due to investors holding them when there’s a particular volatility in the market. Conversely, high-beta stocks are favored when the market is on a steady rise and traders take greater risks maximizing their profits.
Best Risk Management Strategies
Without a reliable risk management strategy, a trader can lose the entire investment in just a few poor trades.
Here are several popular risk management techniques performed by active traders to prevent losses from getting out of hand.
Stop loss
Stop loss is a “buy-or-sell” order that is triggered as soon as the stock price reaches its stop price. This method can be extremely useful for those who don’t want to monitor the security on a continuous basis. A few other advantages of using stop loss are to ensure protection from excessive loss and to control an account more efficiently.
For instance, a trader buys a stock at $50 per share that they feared may drop in price. In this way, they will be able to use a stop order to sell if the price drops below $45 per share to be protected against a larger loss.
Hedge and Diversify
If you put all your capital in one trade, you might be setting yourself up for a great loss. Instead, you can choose to diversify your funds. Not only does this help you manage risks, but also brings additional opportunities along.
Furthermore, you may try hedging your position. Consider a stock position when the results are due. Then, you may take the opposite position through options, to protect your position. When trading activity subsides, you will be able to unwind the hedge.
The 1% rule
The following rule is widely spread with traders who have their accounts balance of less than $100k. The principle itself means never investing more than 1% percent of the capital into one trade. For instance, a trader holding $10k of capital would avoid risking more than $100 on a single trade.
Risk-return ratio
This involves weighing a trade’s risk against its potential return. Say, it tells a trader what reward they can expect for every dollar they risk on an investment. For example, if the risk-return ratio is 1:3, $3 can be earned for every single dollar you risk. Most professional traders will pass by the trades with a risk-return ratio lower than 1:2, while some others only go for trades with a risk-return ratio of 1:3.
Wrapping It Up
Trading takes a lot of hard work and effort to ultimately become a profitable venture. So, if you don’t invest enough time in learning and doing your research to improve your risk management abilities, it is probably better to stay on the sidelines. But if you want to achieve mastery at trading, there can be no shortcuts – you need a sound risk management strategy to secure your capital and ensure the steady sustainable accumulation of profit.
After all, just remember that every minute and every bit of effort spent is worth it because the thrill of becoming successful in the trading business is like nothing else.