Risk management

Risk is an integral part of daily trading – without the willingness to allocate risk capital, no returns can be expected. Modern traders have access to numerous tools that allow them to effectively manage risk and maintain control over their positions.

1. What does trading risk involve?

2. How to develop a risk management plan?

3. Five key principles to remember

What does trading risk involve?

Trading risk refers to the possibility that your returns may fall below expectations or that you may incur a loss of the capital invested in a position. This could include a slight reduction in profits, a total loss of the investment, or being forced to close a position under unfavorable conditions.

Since no trader can accurately predict all market movements, having a well-crafted risk management plan is crucial, especially when trading with leverage, which amplifies both gains and losses.

Three main types of trading risks:

Market Risk

• • Market risk is the most common type of risk, arising from adverse price movements in assets. This is the primary risk traders aim to mitigate.

  • Control measures: Understand the factors that affect market prices. For example:

    • Stocks: Interest rates, forex rates, and other macroeconomic factors.

    • Forex: Political stability and economic data.

  • Tools like stop-loss and take-profit orders are essential, even for experienced traders who know their market well.

Liquidity Risk

• • Liquidity risk occurs when you cannot quickly close a position, potentially leading to reduced profits or losses.

  • Example: You own shares in a lesser-known company, XYZ & Co., and want to sell them, but there are no buyers. To offload the shares, you may have to sell them at a lower price.

  • Solution: When trading CFDs or forex with market makers like FOREX.com, liquidity is usually managed effectively as you don’t physically own the assets, but rather trade based on their value.

Systemic Risk

• Systemic risk refers to broader financial system issues that can affect the entire market.

• Example: A global market crash causing widespread declines in stocks, indices, and other assets.

• Mitigation: Diversify trades across different assets and regions to reduce the impact of market-wide crashes. However, thorough research into each market is necessary before trading.

How to develop a risk management plan

Effective risk management relies on a well-developed plan that considers all aspects of trading, from identifying opportunities to determining position size and exit strategies. Below are the key steps your plan should include:

1. Exit strategy

• Determine your "pain point," or the maximum loss you are willing and able to accept from a specific trade, before entering the market. Letting losses exceed this threshold can lead to serious problems.

• Defining maximum loss: For each trade, set a specific amount or percentage you are prepared to lose. This discipline helps eliminate emotional decision-making.

• Avoid common mistakes: A frequent mistake traders make is holding on to losing trades in the hope that the market will turn in their favor, often leading to greater losses.

• Using stop-loss orders: Consider setting stop-loss orders on all trades. These automated tools protect you from exceeding your limits and help minimize risk.

A good risk management plan is built on discipline and clearly defined boundaries. Establishing an exit strategy before entering the market and consistently adhering to your rules can help protect your capital and increase the likelihood of long-term success.

2. Position sizing

Position sizing is a key practice among professional traders, involving the pre-determination of how much capital to allocate to each trading opportunity. This technique enables effective risk control and reduces potential losses.

• Determining position size: Before initiating your first live trade, calculate the optimal position size based on your account balance. For instance, a $10,000 account will use smaller positions than a $1,000,000 account.

• Risk control: Regardless of your capital size, adjust position sizes to avoid significant losses. This approach promotes the long-term sustainability of your trades.

3. Evaluating opportunities

Carefully evaluate trading opportunities before entering a new position.

• Creating a trading plan: A detailed trading plan is essential for success. It should include identifying opportunities, entry and exit strategies, and risk limits.

• Avoid emotional decisions: Do not open trades impulsively or under the influence of emotions like excitement, greed, or fear. Trading based on random impulses often leads to unnecessary losses.

• Rational trade entries: Rapid market movements are not always a valid reason to trade. Ensure your decisions are based on thorough analysis rather than a fear of "missing out."

Five key principles to remember

Trade in line with the trend

Follow the current market direction and take advantage of its momentum. Choosing the path of least resistance often yields better results.

Have a clear entry and exit strategy

Define specific rules for opening and closing trades to eliminate uncertainty and confusion.

Control risk and act decisively

Maintain discipline in protecting your capital. Your priority is to stay in the market long enough to seize future opportunities.

Trade rationally, not emotionally

Avoid impulsive decisions driven by emotions like fear, greed, or overexcitement. Make logical, analysis-based decisions.

Avoid trading during scheduled news events

News events can cause unpredictable volatility. Ensure that unanticipated price swings do not jeopardize your strategy before entering the market.