Six steps for effective risk management

Creating a risk management plan for trading might initially seem like a daunting task. However, these six tips will help you develop a trading strategy that aligns with your trading style:

1. Define your risk tolerance

2. Adjust the size of each position

3. Set proper timing

4. Avoid weekend gaps

5. Stay updated with the latest news

6. Trade within your financial limits

1. Define your risk tolerance

Every trader has an individual level of risk tolerance.

Trading instructors often recommend risking between 1% and 5% of your total trading account value per trade. However, the exact percentage should depend on your personal comfort level and trading style.

As you gain more confidence in your trading system, you might feel tempted to increase the risk, but be cautious not to go too high.

Remember, the goal of trading is to generate returns or preserve enough resources for future trades.

The table below illustrates how different risk percentages can affect the number of consecutive losses that could potentially deplete your trading account:

Example: If you trade once per day and risk 10% of your account balance per trade, ten consecutive losses could theoretically wipe out your account. On the other hand, if you risk only 2% per trade, it would take 50 consecutive losses to bring your account to zero.

2. Adjust the size of each position

Once you know how much you are willing to risk on a single trade, the next step is to determine the size of your positions.

Finding the right balance is crucial. If you're risking $100 per trade, trading a standard lot size in the EUR/USD pair (100,000 units) might not be a wise choice. For instance, if the pair drops from 1.1300 to 1.1200, you would already hit your risk tolerance for that position.

One of the easiest ways to ensure you're staying within your desired risk amount is by adjusting the size of your positions.

For example:

• A standard lot in currency trading equals 100,000 units, translating to $10 per pip in the EUR/USD pair.

• Conversely, a mini lot is 10,000 units, offering smaller exposure.

Example: Standard Lot vs. Mini Lot

The ability to adjust risk levels according to your preferences and strategies can be a determining factor in achieving trading success.

3. Set the right timing

If you don’t plan to build or purchase an advanced trading algorithm, you will need to actively trade on your own to seize market opportunities. Since many markets operate 24 hours a day, it's essential to decide how much time you can dedicate to trading daily – and determine the hours that work best for you.

Proper timing also helps you maintain the right mindset, which is crucial for effective risk management. For example, trading at 3:00 AM may not result in the most thoughtful decisions.

Using exit orders

Exit orders, such as stop-loss or take-profit orders, are valuable tools for managing risk when you cannot fully focus on the markets.

Setting alerts

Some traders use alerts to notify them when their positions approach predefined maximum loss levels or profit targets. These tools allow you to maintain control over your trades even when you’re not actively monitoring the markets.

4. Avoid Weekend Gaps

The most popular markets in the US close trading on Friday afternoon at 5:00 PM ET. Traders take a break for the weekend, and charts worldwide seem "frozen," as if prices remain unchanged until the next trading session begins. However, this static image doesn’t reflect the actual market activity during the weekend. Prices continue to shift and may undergo significant movements by the time trading resumes.

As noted in the lesson on exit orders, weekend gaps can push prices beyond your stop-loss threshold. To mitigate this risk, it’s essential to include measures for handling weekend gaps in your risk management plan. One simple strategy is closing your positions on Friday afternoon to avoid unforeseen losses.

Although market gaps don’t occur every day, they can happen and often bring unexpected surprises. As shown in the example below, gaps can be substantial and may even bypass your stop-loss entirely if it’s set within the gap range. To reduce these risks, consider closing trades before the weekend or leveraging gap movements through a gap trading strategy.

5. Stay updated on news

News events can have a significant impact on forex markets. Certain announcements—such as employment data, inflation reports, or central bank decisions—can trigger exceptionally sharp market movements. These events may even create sudden price gaps, even while the market is open and active.

Similar to weekend gaps, these sudden shifts can bypass your stop-loss orders or profit targets, often within seconds of major news releases. Unless your strategy specifically involves taking on the risks associated with trading during news events, engaging in trades during such volatile periods demands careful risk management.

6. Trade Within Your Financial Means

A well-known rule in trading is: never invest more than you can afford to lose. This principle is widely emphasized because it is rooted in sound logic.

Trading is inherently risky and unpredictable. Putting your life savings at the mercy of ever-changing market dynamics is rarely a wise decision. Therefore, it is essential to invest your funds thoughtfully, with care and consistency, to safeguard your hard-earned capital.