Risk management is a fundamental aspect of trading. Most successful traders incorporate risk management into their strategies regardless of their experience. Profitable traders will manage their risk in a way that ensures they’re partially protected from suffering significant losses. But what is meant by risk management in trading and why is it so important?

Fully understanding risk management is key to developing a solid trading strategy. Managing risk effectively will help to limit the exposure of your open positions.

What is risk management?

Risk management is the act of mitigating the potential loss that can be incurred from trades. This can be done in a few different ways, and it’s not all down to what you can do – a lot lies with what your broker offers. Considering the high risk involved in trading, any chance to limit what could be potentially devasting losses should be taken and implemented where possible.

The five specific areas of risk management covered in this lesson are: 

Stops and limits – How using risk management tools can help to limit losses and secure profit.
Hedging – How placing trades against current open positions can effectively offset risk.
One percent rule – How abiding by self-applied rules can control your trading and ensure huge proportional losses aren’t suffered.
Mentality – Understanding the right mental state required to trade efficiently.
Discipline – Discipline is one of the most valuable traits a trader can have.

What types of risk management are there?

  • Risk management tools
  • Guidelines and trading rules to follow
  • Trading techniques
  • Self-assessment
  • Self-discipline

Risk management can come in different forms. One of the most popular forms is the risk management tools that brokers offer, which can be used on open positions for different purposes. An example of a risk management tool is a Guaranteed Stop, something offered for free by ETX Capital where open positions are closed regardless of slippage or gapping when prices reach a certain level.

Alternatively, managing risk can co be self-imposed rules that you can follow while trading. For instance, following a certain method such as the one percent rule, can ensure your open positions aren’t leaving too much of your financial capital exposed at one time.

Managing emotions and your own mindset is also a crucial element to being able to successfully manage risk. Being in the wrong state of mind when trading can hinder you’re ability to conduct your own risk analysis on the trades you’re going to make. On the surface it seems simple to control your emotional stability when trading, but it can prove to be difficult.

For example, dealing with a loss, or even dealing with profit, can impact your mentality and encourage you to make a new trade, which is purely reactionary. After closing a trade for a good profit, it can be inviting to immediately re-enter the markets to try to emulate the success. Equally, after an unsuccessful trade it can be tempting to chase your losses. Good traders can resist the temptations and only enter the markets when it’s effective to do so.

Stops and Limits

What are stops and limits?

Stop and limit orders are risk management tools that can open new positions and close existing ones at a desired price level. Stops are exclusively used to close existing positions. A price is set at a trader’s discretion, below the current price for a particular market. If the price falls to that level, the position is automatically closed. This is to limit the amount of money that can be lost on a trade should the market go against your position.

Alternatively, a limit order in trading will either open a new position when a market hits a certain level or close an existing position when the price level is reached. When opening new positions, a limit order can be set at a level with the intention of a position being automatically opened if/when it hits the selected price. Limit orders can also be applied to open positions, and act as an ‘auto cash-out’ function where the trade is closed once it reaches a certain level of profit.

Hedging

What is hedging?

Hedging refers to opening a new position that contradicts a current open position. For instance, if there is a short position open on Bitcoin, hedging would mean opening a long position on Bitcoin.

This can be seen as a negative as even when hedging works out in a trader’s favour, it cuts into profits. That, in essence, is the point of hedging though: It effectively reduces the profit but also reduces potential losses.

Example 1 (Hedging a profitable trade)

-Apple price is 100, and an initial (long position) trade is opened at £1 a point.

-Apple price rises to 150 and so the trade becomes profitable.

-A hedge position (short) is then opened at £0.50 a point (price 150).

Apple price change from 150 to:

First (initial) trade PnL

Second (hedge) trade PnL

Total PnL

0

-£100.00

£75.00

-£25.00

50

-£50.00

£50.00

£0.00

100

£0.00

£25.00

£25.00

150

£50.00

£0.00

£50.00

200

£100.00

-£25.00

£75.00

 

In this example, a position that is profitable is hedged in order to protect the profit already accrued. Here, if the price increases then the trader will still see the PnL rise the more the price rises, but the position also remains semi-protected by the hedge trade should the price to fall considerably back down.

Example 2 (Hedging a losing trade)

-Apple price is at 200, and an initial (long position) trade is opened at £1 a point.

-Apple price falls to 100 and so the trader is losing money from the trade.

-A hedge position (short) is then opened at £0.50 a point (price 100).

Apple price change from 100 to:

First (initial) trade PnL

Second (hedge) trade PnL

Total PnL

50

-£150.00

£25.00

-£125.00

100

-£100.00

£0.00

-£100.00

150

-£50.00

-£25.00

-£75.00

200

£0.00

-£50.00

£-50.00

400

£200.00

-£150.00

£50.00

In this example, a position that is losing money is hedged in order to protect the trader from further losses. Here, if the price increases enough then the total PnL can show profit, but the initial position is still also partially protected by the short hedge trade if the price falls further.

As both of these examples show, a hedge can clearly help to limit losses from an initial trade. It can also cut into profit, but many traders favour risking less to win less. For this reason, they’re happy to hedge against a winning position to protect themselves in case the market suddenly switches against them.

What is the purpose of hedging a position?

There are two main purposes to hedging in trading:

-Protect an open position from an adverse price change.
-Take advantage of a short-term price change that happens to ‘go against’ a current open position.

Protecting an open position – As we saw in the examples above, hedging can be used to protect either profitable open positions in case the price falls or protect losing open positions against further price decreases.

Take advantage of a short-term opportunity – A second purpose of hedging is for short-term trading.

Let’s say a trader believes Apple is the best company around and so opens a long position. Their intention is to keep the trade open long term as they’re sure Apple’s price will grow exponentially over the coming years.

Soon after, a terrible earnings report is then released by Apple, which will affect its price and cause it to fall in value over the coming days. The trader may wish to keep the initial trade open as they still believe in Apple’s long-term prosperity, but they also want to open a new short trade on Apple as they see its price falling following the poor earnings report.

With the second trade (the hedge), the trader’s intention will be to capitalise on the short-term price change of Apple and so they will intend to close the hedge position soon after profit is earned from it.  

One percent rule

What is the one percent rule?

The one percent rule is a form of fund management that ensures only a small amount of your overall bankroll is ever at risk at one time, per position. Following it either means limiting the size of your trades to 1% of your account’s total funds or using stops to ensure loss on a position cannot exceed 1% of funds.

In the first scenario, let’s say a trader has £10,000 in an account ready to trade. The one percent rule would mean the highest value any new position can be opened at would be £100. If the trader wants to buy Apple shares and Apple is trading at a price level of 100, they would only be able to open a position at £1 a point. 

For the second scenario a larger valued position can be opened. So, say the position is opened on Apple at a price of 100, the trader can go £10 a point. This will mean the position will have a total exposure of £1,000, which will be 10% of account funds.

However, following the one percent rule would mean placing a stop at a price level of 90. That way, the position will be closed at a ten-point deficit, which means with the position at £10 a point the total amount of funds risked is £100 (1% of the trader’s £10,000).

What is the purpose of the one percent rule?

The concept behind the one percent rule is designed to ensure that even when the markets go completely against a trade, as they are likely to do at some point, only a very small proportion of the overall account funds is lost.

Essentially, a trader following the one percent rule can have 99 positions that have lost the full amount of equity risked, and still have funds in their account to trade (1% of their original total funds). Of course, this is an extreme example, but it just shows the value and longevity that the one percent rule can bring to your trading.

Furthermore, this form of risk management does not directly limit the potential for profit. Smaller trade sizes do equate to smaller profits, but unlike other forms of risk management, following the one percent rule does not mean having to close a position at a certain price level.

Mentality

One aspect of risk management is assessing intended trades and personally determining the risk that comes with it, and whether opening a position is a good decision. It’s vital to be in the correct frame of mind when placing trades, to ensure judgement is not clouded and prevent poor decisions from being made. Trading while angry or when there’s an emotional interest in an asset, such as wanting to trade your favourite sports team, can result in losses.

Another vital mistake that traders make regarding mentality is trying to chase losses or keeping a trade open in the hope that it will return to profitability. It’s important to have a clear value or time frame in mind before a trade is placed, be it a certain level of loss or gain, where the position will be closed. Losing trades shouldn’t simply be kept open in speculative hope that their prices will suddenly change for the better.

Equally, if loss is incurred, accept it and move on. Every trader suffers losses, but profitable traders do not let it affect future judgement or dictate their next actions.

You should never place a trade:

  • When you’re angry, upset or emotion clouds judgement
  • Haven’t thought about the implication if the maximum amount of equity is lost
  • When you are unsure about the market
  • If you are simply chasing losses
  • If you are only trading out of boredom

Discipline

Another self-risk managing aspect that must be focussed on is discipline. Discipline is related to mentality and refers to not only closing trades, but only opening positions that have been carefully thought about beforehand. It’s simple to convince yourself why a trade will be a good, profitable one, but successful traders are often the ones that can be honest with themselves and only place well-though-out trades.

When a trade is in profit, it’s easy to leave it open in the hope it will make further gains. This can work out in your favour, as continual gains will add to that profit, but at some point the market will begin to fall. What you must decide is when to close the trade and take your profit, ensuring that greed doesn’t eclipse logical judgment.

It’s very rare that you’ll close a position at its peak, so closing profitable positions will often undercut a small amount of value. However, it’s a much better trading strategy to take sufficient profit when it comes than to leave a trade open and watch it fall back down into the red.

 

 

 

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