Many trading strategies involve risk management, but risk management in itself can require strategy and planning. It’s easy to assume that simply undertaking risk management practices is enough to limit losses, but that would only be scratching the surface. Like most aspects of trading, devising a well-though-out strategy with risk management and implementing it effectively will best set you up to become a profitable trader.
Profitable traders leave nothing that’s in their own hands to chance. Thorough strategies are put in place for managing their risk, no matter how confident they are in a market or their own trading abilities.
Adaptability is key
The markets are fluid, so you should be too. As important as it is to plan aspects of your trading ahead of time, adapting and reacting to the market’s current situation is an important factor in effectively managing your risk.
For instance, you may have a strategy to place stop loss orders on all trades 50 points below the price that you open the positions at. If, however, the markets are particularly volatile, it may be worth extending out the stop loss orders to 100+ points below the open price.
This is because the range for the markets experiencing volatility is going to subsequently be wider, so it makes sense to adjust the stop loss order and widen it as well. In keeping a stop loss order too close to the opening price, you give yourself less room for fluctuation. It would be like placing a stop loss order one point below a current market price. Markets have small fluctuations all the time for, so in times of high volatility a larger range of fluctuation should be accounted for.
Similarly, if the markets become more docile while you are following the one percent rule, depending on how comfortable you are risking more of your equity, you might choose to increase your exposure to counter the lack of volatility in the markets. Potential profit (and loss) is great when there’s either high volatility or high trading volume, so when there’s no volatility a larger trading volume is needed to have the same potential profit.
Trailing stops are your best friend
A trailing stop is a great tool if you want to be adaptable, due to its ability to move as the price of a market moves.
Regular stops simply execute the stop loss order when the predetermined price is hit. For instance, if Apple is priced at 100 and a stop loss order is implemented at 80, the position will be closed at 80 all things being equal. They are useful, but when a market is specifically volatile, they are too rigid and can severely cut into profits.
With trailing stops moving with the markets, they can secure profit at higher levels and still protect you from sustaining heavy losses. So instead of setting a price level where the position is closed, you select a percentage or certain amount below the market price at any given moment. This means that if a market rises 100 points and then suddenly falls back down 100 points, profit from that temporary spike will be earned – where with normal stops it would not be.
Leverage and margin
Leverage and margin are both a trader’s best friend and worst enemy. It can enable you to take up larger sizes then you would normally be able to open, but equally as the potential for profit rises, so does the size of the risk.
Pros and cons of Leverage and Margin
-Only a fraction of the total asset value is needed to be invested by the trader.
-The risk increases as the trader is exposed to larger amounts.
-The trader can benefit from an increased exposure.
-In essence, the trader won’t be trading with their own funds so a large loss could potentially wipe
-Traders have greater investment opportunity, so they have the chance to expand their portfolios.
-There’s an increase in pressure and stress that could be detrimental to a trader’s decision making.
Most traders use margin and trade on leverage, simply so that investing in large quantities of the most valuable assets is feasible. There’s nothing wrong with this, but it means that a lot of care is needed and exposing yourself to several open positions that use high leverage is dangerous.
The concept behind risk and reward ratio is simple and can be related to decision-making in general, not just trading. Put simply, it’s evaluating whether the potential risk (in terms of trading it will be the amount of money stakes to open a position) is worth taking to gain the reward (the profit that can be earned from a trade.
Let’s use an example in a casino. If a casino offered you £1,000,000 to hit one number from one spin of a roulette wheel, but you must stake £1,000, would it be a good deal? Let’s break it down. The odds of hitting one selected number on a roulette wheel is 37:1 (numbers 1-36 and then green 0 to make it 37:1), and the usual payout is 36:1. In this case, the casino is offering an enhanced payout of 1000:1 (£1,000,000 prize money/£1,000 stake =1000).
Clearly this is a very good offer, so despite £1,000 being a large sum for the average person to wager, the risk/reward ratio of 1000:1 suggests it’s definitely worth the risk – because once every 37 spins you’ll win £1,000,000. So, with a risk/reward ratio of 1000:1 and a probability of 37:1 of winning, this demonstrates good value and would be great investment.
Of course, this is an extreme case. In trading, there is nothing like this kind of risk/reward offer. Let’s say Apple’s price has fallen from 150 to 100. At this price, you think Apple is a good investment and you see it rising back to 150 so you want to invest £1 a point.
That would mean risking £100, to win £50 (let’s say you would take the profit once it returned to 150). Here, the risk/reward ratio would be 1:2 as you would be risking £100 to return £50 profit. It’s up to you to decide whether it’s worth investing based on that ratio and whether or not the chances of Apple’s price rising to 150 is enough to justify the trade.
Outline a clear plan and stick to it
As much as we have preached the importance of adapting, outlining a plan and sticking to it is also crucial. If, for instance, you have implemented a plan to risk only 1% of your total funds on any given position (one percent rule) and after a week you’re suffering huge losses, it would be foolish to conclude that the risk management strategy hasn’t worked.
Firstly, determining how effective a strategy has been should not be based on simply whether profit has been made. The purpose of managing risk is to ease losses; not necessarily prevent them all together – sometimes loss is unavoidable. Were you not to stick to the 1% rule, heavy losses may have been suffered, so risk management has worked in preventing loss to a certain extent.
Secondly, perhaps the strategy is not in fitting with your trading style, but even so, one week is not long enough to determine whether or not a strategy is working. Try it out for three months, and if you feel that your strategy lead you to, for instance, undercut value on your trades, that’s the time to revaluate and adapt your risk management strategy.
One other dynamic to be aware of is how certain markets correlate with one another. Take cryptocurrencies as an example. Bitcoin is seen as the staple crypto, and thus often dictates the rest of the market. If Bitcoin’s price rises, on most occasions Ripple, Ethereum and the other major altcoins’ prices rise too.
Similarly, certain currency pairs also correlate with one another, simply by sharing a common currency. For instance, EUR/USD and GBP/USD will both be affected in a similar way were something to heavily affect the dollar.
Why is this significant when it comes to managing risk? If you have multiple positions that correlate with one another, meaning they are likely to all rise and fall together, your exposure is greater. Each position may only be 1% of your total funds, but if they all hinge on the same influencing factor (i.e. a specific currency) then your exposure will be much greater than 1%
Say you have ten positions open involving different USD fx pairs. Should the dollar move against your positions (assuming they’re either all short or all long), all ten of those positions will be down and 10% of your total funds may be lost.
It still doesn’t sound too disastrous, but it’s just something that’s worth considering when you’re about to open new trades or assessing current positions.
Each and every day, an announcement, scheduled meeting or piece of news will come out that affects the markets. Most of which are planned, but there are also many adhoc developments that have an equal, if not greater, impact on markets.
As a consequence, your open positions are likely to be significantly affected multiple times throughout a month. For instance, an open position in Apple will be heavily affected by an earnings report, so knowing when Apple’s next quarterly report is due is crucial to know when your trade’s price may fluctuate. In knowing when this will happen, you can then plan your strategy to manage the position’s risk accordingly.
We offer our ‘Week ahead’ update every Sunday, that includes an Economic Calendar that notes all the important events to look out for over the coming week.
Our Analysis section also has updates for significant economic events that can affect the markets, such as an earnings report breakdown. So be sure to utilise the wealth of channels available to you to remain as well informed as possible.