What is risk management?
Trading is a serious business in which traders look to capitalize on the price swings of the various financial assets. Just like any other business, trading too has some risks associated with it.
No profits are earned without risks taken. Risks may not always be in monetary terms but could be present in other forms. The road to profitability depends on the manner in which risks are managed.
Risk management in trading is the simple act of taking care of the risks that one might be exposed to while they are in trades.
A trader that has gone long in a financial asset is exposed to the risk of losing money in forex if the price of the asset falls and if he has taken a short position then he loses money if the price increases.
If traders are unable to manage the risks, they will never be able to make consistent profits in the markets.
Traders might lucky every now and then by earning profits without any management of risk but when luck runs out, the loss they will incur will wipe out not only profits but the capital too.
There are various methods by which traders can manage the risks. You might already know some of the risk management techniques but I urge you to stick around till the end and I assure you that it will be worth your time.
17 Risk management techniques
1. Educate yourself about risk
How can a trader manage a risk he might be exposed to if he doesn’t even know the risk exists?
Managing every possible risk is not feasible as risks are not present in one particular form only. But the imminent risks can be and should be managed.
Lets consider a trader A that has taken a long position in the forex market in one of the currency pairs. The most basic and imminent risk he is exposed to here is that of the price of the currency pair to decline.
In such instances risks are easily spotted but there are some financial products traded that are a tad bit complex and have various factors in play.
Before putting on any trade, traders must be aware of the risks he will be exposed to when a gets into a trade. This will allow them to plan if faced with such situations rather than being caught off guard.
2. Plan, journal, review
One of the most important risk management techniques is of planning a trade before it is entered into.
It is utterly foolish to wake up one day and to place an order on the broker terminal. The next thing we know we have our capital wiped out.
Planning a trade is about having a rationale for the trade. The trade decision could be based on the various types of analysis that traders utilize.
A trade once over, be it in a profit or a loss must be noted down and entered into a journal. The entries must contain every single detail about the trade.
Journal entries allow traders to review the trades they entered into. Traders can then spot any mistakes done by them and can avoid making such mistakes in the coming trading sessions.
3. Set stop loss first
You performed a detailed analysis on any particular financial asset and arrived at a decision to trade the same. You place the order for buy or sell and the order is filled. What will you do next?
Place the Stop Loss order first. It is basic human nature to think about the profits that one stands to make if the trade goes their way.
Doing so will make you oblivious to the risks or the loss you can incur if the trade goes south.
First, place the stop loss order and then place the Take Profit order if your strategy says so. Having protection is not just better but is essential.
4. Use trailing stop loss
Placed a trade? Placed the Stop Loss order before placing the Take Profit order? If yes, then you got my respect. If no, then you seriously have to reconsider your place in the trading business.
There are many strategies out there that traders use to capitalize on price swings of financial assets. Some strategies have fixed targets while some can be tweaked to accommodate flexible targets.
If you trade a strategy that allows you to capture a good chunk of price swings then it is always better to trail your stop loss and lock in some of those hard-earned profits.
Now there are many strategies to trail stop loss, it all depends on the trader and his strategy. Some might not trail the stop loss at all and it’s totally fine. But if we have got the option to do so then it must be considered.
5. Be flexible in stop loss positions
Stop losses are not the same for every financial asset traded. Different assets have different characteristics like volatility and volumes and hence will have different stop loss accommodations.
Assets that are relatively less volatile in their price movements will have smaller stop losses as traders can be ensured that the asset will not have a sudden wild price movement that will kick them out of the trade.
While those that are volatile will require wider stop losses in order to keep space for the volatile price swings and to ensure that the trader stays in the trade.
Traders should not have a blanket stop loss amount for every asset they trade. Stop Losses depend on the strategy being traded but it should also depend on the asset being traded.
6. Position sizing
Position sizing is the determination of the quantity of the financial asset to be traded. This is done in line with the risk tolerance of the traders.
Position sizing and stop loss go hand in hand. Once a trader knows his entry price level and stop loss level, he must size his position accordingly before entering.
Good traders never risk more than 1-3% of their trading capital in any given trade. They know their risk limit beforehand and stick to it every time.
In order to determine how many positions to trade, traders will divide their maximum risked capital by the stop loss amount. This will give them the appropriate quantity to trade.
7. Only trade the money you don’t need
I mentioned the 1-3% rule i.e. never risk more than 1-3% of your trading capital in any given trade. How to determine this?
Simple, by deciding how much money you are comfortable with losing in the trade. Before entering any trade, visualize the possibility of the trade going against you. And then determine how much money from your capital you can afford to lose without any hesitation.
Losses hurt and I understand that but if an individual has decided to participate in this activity of trading then he has agreed to take the risk of losing money in the trade.
Losses mess up the psychology of the traders and it's always better to lose only what you are comfortable with rather than to lose an amount bigger than your risk tolerance.
8. Never act emotionally
Traders have to be at their best if they want to stay in this game for long. There is no place for emotions in this business and individuals that are in this have to be practical and analytical in their approach to the financial markets.
Allowing emotions to take the better of you will lead to poor results. If you have a plan in place then let it play out. If you are confident in your plan then you wouldn’t even think about interfering in it.
It often happens that traders close out their positions if they see that the markets are going against them and are close to their stop loss price limits.
This shouldn’t be done and one should wait for stop loss to get hit as it will be a clear indication that the plan didn’t work out.
What if after you panic exited, the market reversed and breached your take profit level. Losses feel bad, but missing out on profits by not following the plan feels worse.
9. No FOMO
FOMO stands for Fear Of Missing Out. It is a psychological thing that individuals experience when they miss out on an opportunity and then make a rash decision to make for it.
FOMO in traders is quite common. It happens many times that traders miss out on good trades due to any reason whatsoever. Weak traders will take entries at the wrong price levels only to see that it was a bad decision.
The markets are dynamic. The prices keep moving from the opening bell to the closing bell. Traders get several trade opportunities throughout the day and can always choose what opportunity to grab and what to let go of.
There is always another trade opportunity around the corner and if one is missed then the next one can be taken.
10. Set the right expectations
High expectations in trading are dangerous. Most individuals are attracted towards trading owing to the high price swings of assets and then dream of becoming rich after a couple of trades.
This is the best recipe for disaster. Having high expectations will lead to taking higher risks on the trades in order to get high returns. You might lucky once in a while but in the long run, you will wipe out your trading capital.
Expectations are to be set on the basis of the strategy being traded and the asset. If the strategy can fetch higher targets then go ahead and place the take profits accordingly but manage the risk accordingly.
A trading plan that is properly backtested will give the best idea of what to expect and how much to expect. Hence, a well-backtested trade plan is the trader’s arsenal.
11. Find the right strategy
Finding the right strategy is like finding the right shoe. It must fit well. Traders are humans after all and have their own unique characteristics and personalities. Each trader will have his own risk-taking capacity and can only handle so much action.
It is essential that traders find a strategy that fits their personality the best as trading the wrong strategy will lead to loss and this is a risky affair.
There are numerous strategies out there that can be traded. Trading a strategy that is too much to handle is a sign of poor preparation and is bad for risk management.
12. Keep risk consistent
Every now and then traders come across a trade setup that tempts them the most. Just by looking at how things align they can identify a potential trade that can be a huge winner.
A not-so-good trader will increase the risk taken on such trades in order to get more returns. A good trader will stay consistent with his risk capacity and will let the market play it out rather than him tweaking his plan.
No matter how well the trade lines up, no matter how many confluences you can see, do not increase the risk taken. If you are comfortable with risking 2% per trade then risk that much only on all trades no matter how well it looks.
Trading is a game of probabilities. A well-backtested system will give the probabilities of the system and the chances it has of profiting. In order to allow the probabilities to play out correctly, risk limits should not be tampered with or else the results will deviate.
13. Don’t set daily targets
Traders often keep a goal of earning a specific amount daily. They have an obsession with the amount they made in a day and look to satisfy their ego by doing so.
Keeping a daily target will result in chasing trades to meet the targets. We do not have to be in a position to chase the trades but rather just let the trades come to us and give us the opportunity to profit.
14. Always compare win rate and RRR together
Traders that believe in backtesting a strategy or trade setup before taking live trades based on them will have several metrics to judge the strategy or setup. Win rate and RRR are some of the metrics.
The win rate and RRR i.e. Risk Reward Ratio give the trader an idea of how the strategy will perform over the long run. This is useful information that further allows traders to determine the risk parameters for the trades.
A high win rate might look attractive but if the RRR is low then it no longer is attractive. Traders need to find the right balance between the two, all on the lines with their risk capacities.
15. Understand and control leverage
Leverage is a kind of line of credit provided by brokers to their clients. Clients can use this loan to take on positions in the financial market. Leverage depends on the market and the broker.
Leverage is considered to be a double-edged sword. If traders are unable to utilize it properly then it could lead to an ugly situation. But if the leverage is made good use of then it could improve the trading journey of the trader.
Traders often get mesmerized by the high leverage provided by brokers and they go on to take heavy positions in the markets and exposing themselves to huge risks, more than what their capital can handle. A small move against them can eat up a good chunk of their profits.
Staying within risk limits and using leverage accordingly is essential.
16. Keep an eye on news events
By this, I do not intend to promote fundamental analysis. News events are important catalysts to price swings and traders must be aware of them.
Traders that do not trade based on news can choose to avoid trading during the period while for some traders the news provides them with trading opportunities.
Staying aware of the macro scene will help avert some unforeseen losses that can happen because of some massive news drop. Staying aware is better than being caught off guard.
17. Paper trade
Before getting on with trading in the live markets, every trader must spend some time practicing the skills they have learned. Time spent in practice is never time wasted.
Paper trading is one means through which traders can get in their hours of practice. It allows traders to trade in a simulation of the markets where trades are not exactly placed in the markets but rather on a virtual platform.
Through this practice experience, traders can learn the valuable skill that is best learned through experience and that is of risk management.
Being in a simulated environment is not exactly like the actual one but it sure can be used to get adept to the market before actually trying it out.
Do you manage risk properly?
I believe that if you apply these 17 techniques in your trading activities then you will become a better trader and you will notice the results instantly.
Answer this question sincerely, are you that type of trader that manages risk properly? If yes, then great. If no, then do you like losing money?
Share this blog post with others and let them also make good use of these techniques and elevate their trading journey.
Reach out to me through the comments section for absolutely anything and I will get back to it for sure.