Risk Management Techniques for Trading

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Risk management is a key component to a successful business strategy that is often overlooked. By applying risk management techniques, traders can effectively reduce the detrimental effect that losing positions have on the value of a portfolio.

Continue reading to learn more about:

  • Why risk management is important
  • How to manage risk in business
  • Business risk management tools

Why is business risk management important?

Many traders see trading as an opportunity to make money, but the potential for loss is often overlooked. By implementing a risk management strategy, a trader will be able to limit the negative effects of a losing trade when the market moves in the opposite direction.

A trader who incorporates risk management into the trading strategy will be able to benefit from additional movement while minimizing downside risk. This is achieved through the use of risk management tools such as stops and limits and trading a diversified portfolio.

Traders who choose to forego the use of trade stops run the risk of holding positions too long in the hope that the market will turn. This has been identified as the number one mistake marketers make, and can be avoided by adopting the characteristics of successful traders to all trades.

How to Manage Risk in Business: Top Tips and Strategies

Below are six risk management techniques that traders of all levels should consider:

  1. Determine the risk/exposure up front
  2. Optimal stop loss level
  3. Diversify your portfolio: the lower the correlation, the better the diversification
  4. Keep your risk consistent and manage your emotions
  5. Maintaining a positive risk to reward ratio

1) Determine the risk/exposure beforehand:

Risk is inherent in every trade, therefore it is essential to determine your risk before entering the trade. A general rule of thumb would be to risk 1% of the account equity on a single position and no more than 5% across all open positions, at any time. For example, the 1% rule applied to a $10,000 account would mean that no more than $100 should be risked on a single position. Traders will then need to calculate their trade size based on how far the stop is placed to risk $100 or less.

The advantage of this approach is that it helps maintain the account equity after a run of failed trades. An additional benefit of this approach is that merchants are more likely to have free margin available to take advantage of new opportunities in the market. This avoids having to give away such opportunities due to margin tied up in existing businesses.

2) Optimal stop loss level

There are many different approaches that traders can use when deciding where to place a stop.

Traders can set stops according to:

  • Moving averages – set stops above (below) the specified MA for long (short) positions. The chart below shows how traders can use the moving average as a dynamic stop loss.

using a moving average as a risk management tool

  • Support and resistance – set stops below (above) support (resistance) for long (short) positions. The chart below shows that the stop is placed below support in a a vast market allowing the trade enough room to breathe while protecting against a large downward move.

stops near support and resistance as a risk management strategy

  • Using the Medium True Range (ATR) – ATR measures the average pip/dot movement in any security over a given period and provides traders with a minimum distance to set their stops. The chart below adopts a cautious approach to the ATR by setting the stop distance in line with the maximum ATR reading of recent price action.

using a middle true interval in a risk management strategy

* Advanced Advice : Instead of using a normal stop loss, traders can use a trailing stop to mitigate risk when the market moves in your favor. The trailing stop, as the name suggests, moves the stop loss up on winning positions while maintaining the stop distance, at all times.

3) Diversify your portfolio: The lower the correlation, the better the diversification

Even if the 1% rule is adhered to, it is important to know how positions can be correlated. For example, the EUR/USD and GBP/USD currency pairs have a high correlation, which means they tend to move close together and in the same direction. Trading highly correlated markets is great when trades are moving in your favor, but it becomes a problem with losing trades because the loss of the one trade now applies to the correlated trade as well.

The chart below depicts the high correlation observed between EUR/USD and GBP/USD. Notice how closely the two price lines track each other.

correlation between eur/usd and gbp/usd

Having a good understanding of the markets you trade and avoiding highly correlated currencies helps to achieve a more diversified portfolio with reduced risk.

4) Keep your risk taking consistent and manage your emotions

After traders make a few winning trades, greed can easily kick in and entice traders to increase trade sizes. This is the easiest way to burn capital and put the trading account in danger. For more established traders however, it is fine to add to existing winning positions but maintaining a consistent framework when it comes to risk should be the general rule.

Fear and greed rear their ugly head many times when trading. learn how to manage fear and greed in business .

5) Maintain a positive risk to reward ratio

Maintain a positive risk to reward ratio is critically important to managing risk over time. There may be losses early on, but maintaining a positive risk to reward ratio and following the 1% rule on each trade greatly improves the consistency of your trading account over time.

The risk to reward ratio calculates how many pips a trader is willing to risk, compared to the number of pips a trader will receive if the target / limit is hit. A 1:2 risk to reward ratio means that the trader risks one pip to make two pip if the trade works.

The magic within the risk to reward ratio lies in its repeated use. We discovered in our Traits of Successful Traders research that the percentage of traders who used a positive risk to reward ratio tended to show profitable results against those with a negative risk to reward ratio (page 7 of the guide). Traders can still be successful, even if they only win 50% of their trades, as long as a positive risk to reward is maintained.

* Advanced Advice : Traders often get frustrated when the trade moves in the right direction only for the market to turn right and trigger the stop. One way to avoid this happening is to use a two-lot system. This strategy looks to close half the position when it is halfway to the goal and then bring the stop on the remaining position to balance. This way the traders get the profit on the one position while essentially staying with a risk-free trade on the remaining position (if they use a guaranteed stop).

1) Normal Stop Loss : These stops are the standard stops offered by most forex brokers. They tend to work best in non-volatile markets, because they are prone slip . Slippage is a phenomenon where the market does not actually trade at the specified price, either because there is no liquidity at that price or because of a gap in the market. As a result, the trader has to take the next best price, which can be significantly worse, as shown in the USD/BRL chart below:

usd/brl market gap risk management

2) Guaranteed Stop Loss : Guaranteed stop completely eliminates the problem of slipping. Even in volatile markets where price can gap, the broker will honor the correct stop level. However, this feature comes with a cost as brokers will pay a small percentage of the trade to guarantee the stop level.

3) Trailing Stop Loss : Trailing stop moves the stop closer to the current price on winning positions while maintaining the same stop distance at the start of the trade. For example, the GBP/USD chart below shows a short entry that is moving favorably. Every time the market moves 200 pips, the stop will automatically move along with it, maintaining the initial stop distance of 160 pips.

Trailing stop as a form of risk management

Further reading to improve your risk management skills

  • Find out how leverage risk-to-reward ratios and stops are appropriate in the risk management process and why it is important for marketers to have a solid understanding of these concepts.



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