There are several key tools that help you manage risk on your trades, but it is important for traders to have an understanding of the key elements to calculating the amount being risked on each trade. It is also important to understand that margin and trade risk are two different elements.
Here is an example of how to calculate trade risk:
- You decide to go long on GBP/USD which is trading at 1.29465 with a required margin of £432
- Based on your analysis you place a Stop at 1.28945
- If the market price drops below this figure, 52 pips from your opening price, your position will automatically close out
- At £1 a pip your potential loss will be £52, your margin of £432 will be freed up
In this trade example, you are risking £52, not £432. This is the difference between margin and trade risk.
Understanding what effects your trade risk
Understanding risks associated with your positions and implementing tools to effectively manage this risk are key components of trading financial markets. Below you will learn more about the different risk management tools available, the importance of position sizing and understanding pip calculation.
Stop Loss Orders
Stop loss orders are attached to open or pending orders and come in a variety of forms depending on the market and the current conditions. A standard stop loss order will close out an open position when the market has traded at the price level.
A trailing stop allows the stop to move in preset increments in relation to the current trading price if the position is moving favourably. The stop will never move back against the trade if the market price moves unfavourably, it will remain at the level where the position will either be stopped out or trailed further if the price continues to move in the right direction. Initially, stop-loss orders can only be placed to counter your opening position, e.g. a buy limit/stop would require the stop loss to be placed below the opening price, a sell limit/stop would require the stop loss to be placed above the opening price. Stop loss orders can be amended where applicable but only to a position which counters the trade.
Position sizing is the method used to calculate how much the trade gains or risks per pip movement. A trader is able to determine the risk on the position by calculating the difference between their entry price and the stop loss level. Stops are placed in positions based on a number of factors, these may include risking a certain amount of funds based on your account value and/or placing a stop on a technical level. Understanding how much per pip is being risked and where your stop is placed is key in understanding your total risk on the trade.
When determining how much per pip a position will gain or loss, a trader needs to understand what size constitutes a pip movement. CFD and Spread-betting have different calculation methods, this is because CFDs are based on a standardised contract for each market and spread betting prices every market on a per point basis in the accounts denominated currency.
For more information on how to effectively manage your risk, click here for our detailed guide.