Risk Management Strategies
Any professional investor and or a successful trader would agree the importance of managing risk. However, the question arises on how does one go about managing that risk? And what exactly do they mean by managing risk? Here is a step-by-step guide to one of the most important concepts in financial trading.
Risk Tolerance: This is a personal choice for anyone who plans on trading any market. Most trading instructors will throw out numbers like 1%, 2% or on up to 5% of the total value of your account risked on each trade placed, but a lot of trader’s comfort level with these numbers is largely based on the level of experience and knowledge. Newer traders are inherently less sure of themselves due to their lack of knowledge and familiarity with trading overall or with a new system, so it makes sense to utilize the smaller percentage risk levels. Once a trader becomes more comfortable with the system they are using, they may feel the urge to increase the percentage, but be cautious not to go too high. Sometimes trading methodologies can produce a string of losses, but the goal of trading is to either realize a return or maintain enough to make the next trade. For instance, if a trader has a trading method that places one trade per day on average and they are risking 10% of their beginning monthly balance on each trade, it would only theoretically take 10 straight losing trades to drain their trading account. So even for an experienced trader, it doesn’t make much sense to risk so much on one single trade. On the other hand, if a trader were to risk 2% on each trade, they would theoretically have to lose over 40 consecutive trades to drain their account.
|STARTING BALANCE||% RISKED ON EACH TRADE||$ RISKED ON EACH TRADE||# OF CONSECUTIVE LOSSES BEFORE $0|
Customize Positions: The amounts of methodologies to use in trading are virtually endless. Some methods have a trader use a very specific stop loss and profit target on each trade they place while others vary greatly on the subject. For instance, if a particular trader uses a strategy that calls for a 25-pip stop loss on each trade and you only trade the EUR/USD, it would be easy to figure out how many positions they may want to enter to achieve their desired result. However, for those strategies that vary on the size of stops or even the instrument traded, figuring out the number of contracts to enter can get a little tricky.
One of the easiest ways to make sure they are getting as close to the amount of money that they want to risk on each trade is to customize your position sizes. A standard lot in a currency trade is 100,000 units of currency, which represents $10-11/pip on the EUR/USD trading at 1.10 if a trader has a U.S. dollar (USD) as their base currency; a mini lot is 10,000. In the realm of trading, having the flexibility to risk what you want, when you want, could be a determining factor to your success.
Timing: There may not be anything more frustrating in trading than missing a potentially successful trade simply because there wasn’t available time when the opportunity arose. With FX being a 24-hour-a-day five day a week market, that problem presents itself quite often, particularly if a trader trades smaller timeframe chart. The most logical solution to that problem would be to create or buy an automated trading system, but that option isn’t viable for a large segment of traders who are either skeptical of the technology/source or don’t want to relinquish the controls. That means that a trader must be available to place trades when the opportunities presents itself, in person, and of full mind and body. Waking up at 3am to place a trade usually doesn’t qualify unless they are used to getting only 2-3 hours of sleep. Therefore, the average person who has a job, kids, soccer practice, a social life, and a lawn that needs to be mowed needs to be a little more thoughtful about the time they want to commit. Perhaps 2-Hour, 4-Hour, or Daily charts are more amenable to that lifestyle where time may be the most valuable component to trading and balanced lifestyle.
Another way to manage risk when a trader or an investor is not in front of their computer is to set trailing stop orders. Trailing stops can be a vital part of any trading strategy. They allow a trade to continue to gain in value while the market price moves in a favorable direction, but automatically closes the trade if the market price suddenly moves in an unfavorable direction by a specified distance.
When the market price moves in a favorable direction (up for long positions, down for short positions), the trigger price follows the market price by the specified stop distance. If the market price moves in an unfavorable direction, the trigger price stays stationary and the distance between this price and the market price becomes smaller. If the market price continues to move in an unfavorable direction until it reaches the trigger price, an order is triggered to close the trade.
Price Gap’s (Weekends & Public Holiday’s): The financial markets, assets and traded products close their doors on Friday afternoon Eastern Time in the US. Investors & traders pack up their things for the weekend and or public holiday’s, and charts around the world freeze as if prices remain at that level until the next time they can be traded. However, that frozen position is a fallacy; it isn’t real. Prices are still moving to and from based on the happenings of that weekend or holiday and can move drastically from where they were on Friday until the time they are visible again after the weekend or when market resumes trading. This can create price “Gaps” in the market that can run beyond a trader intended stop loss or profit target. For the latter, it would be a good thing, for the former – not so much. There is a possibility that a trader could take a larger loss than they intended because a stop loss is executed at the best available price after the stop is triggered; which could be much worse than they planned. While gaps in the FX markets are not common, when they do occur, gaps can catch traders off guard. As in the illustration below, the gaps can be extremely large and could jump right over a stop if it was placed somewhere within that gap. To avoid them, professional traders simply exit trades before the weekend or public holiday’s, and perhaps even look to exploit them by using a gap-trading technique.
News & Events: news and important events can be particularly perilous for traders who are looking to manage their risk as well. Certain news events like employment, central bank decisions, or inflation reports can create abnormally large moves in the market that can create gaps like a weekend or holiday gaps, but much more sudden. Just as gaps over the weekend can jump over stops or targets, the same could happen in a second or so after a major news event. So, unless a trader is specifically looking to take that strategic risk by placing a trade before the news event, trading after those volatile events is often a more risk-conscious decision.
Make It Affordable: There is a specific doctrine in trading that is extolled by professionals, and that is that a trader should never invest more than they can afford to lose. The reason that such a widespread accepted manifesto is that it makes sense. Trading is risky and difficult, and no sensible trader should put their own livelihood at risk on the machinations of market dynamics that are varied, highly complex and next to impossible to predict. So, a trader should not risk away their hard-earned trading account and should invest it in a way that is thought through, intelligent and consistent.
Managing risk is one of the most important aspects of successful trading. At Sandton Capital Markets we strongly encourage all our trading clients to exercise caution and utilize strong risk management tools. It’s impossible for traders to know with certainty how a price of any financial asset will move at any given time. But, what they can do is take full advantage of the times when they are right and attempt to minimize risk as much as possible for the times when they are wrong. A goal is to target longevity when trading so that your account will survive to trade another day.
There are four main things to keep in mind when planning risk management strategies and we’ll look at each of them in turn:
- Hard Stop Loss: The stop loss is designed to do exactly what the term suggests; it takes the trader out of a trading position at a certain pre-determined point when the position has a negative value. The most common form of stop-loss is the “hard” stop loss, where the trading platform is pre-configured to close a position at a specific price level where the position would show a loss. Using hard stop losses is an extremely important aspect of risk management as it allows the trader to clearly define their risk tolerance for each trade. Stop losses should be placed according to market conditions and should strike a balance between being too close to the market price and too far. Stop losses can also be moved during an open trade to lock-in or break even on any profits that may have been made. However, stop losses should only be moved in the direction of the trade, and not in the opposite direction. Moving stop losses in the opposite direction of a trade can potentially leave a trader with substantially larger losses.
Mental Stop Loss: Another kind of stop loss is called a ‘mental’ stop loss. It’s not really a stop loss at all. It simply consists of a trader telling themselves that a position should be manually closed at a certain point. If the trader lacks the discipline to act upon a mental stop loss, however, trading losses could potentially grow very quickly on a losing trade. Mental stop losses only work if a trader has enough discipline to close their losing position when the predetermined price is reached, which can be tough for even the most experienced traders.
- Entry Limit: Entry Limits are orders that are placed by traders to enter the market at a more favorable price than the current price. When buying a currency pair or a CFD, an Entry Limit will be placed below the current market price. When selling, an order will be placed above the current market price. When placing Entry Limit orders, the trader expects that the market price will bounce back after it reaches the level at which the entry limit order was placed. For example: If EUR/USD trades, you might expect the pair to trend higher. But, maybe you prefer going long at a better price – and you expect the price to go down to 1.0525 before it continues going up. So, you place an Entry Limit buy order of 1 lot (EUR/USD) at 1.0525. When the rate reaches 1.0525, the limit order will be executed, and the EUR/USD will be bought at 1.0525.
Entry Stop: Entry Stop orders are orders placed by traders to enter the market at a less favorable price than the current price. A buy Entry Stop order is placed above the current market price. A sell Entry Stop order is placed below the current market price. When placing Entry Stop orders, the trader expects that once the market’s momentum breaks through the specified price, the trend’s movement will be confirmed and continue in that direction. For example: If EUR/USD is trading, and you estimate that EUR/USD will continue trending higher and that if the currency pair breaks above 1.060, it will rise by at least 50 pips, then you would place your buy Entry Stop order EUR/USD at 1.0600.
- Position Sizing: Besides the use of hard/mental stop losses, trade positions should also be sized with prudence. The amount of market points risked – as defined by a position’s stop loss – combined with the size of the position, dictates the actual financial risk a trader is taking on a position. Generally, risk on any single trade should not exceed a maximum of 3-5% of the trading account’s total capital. Professional interlay traders may risk significantly less than 5% on each trade.
- Reward/Risk Ratio: The reward/risk ratio is another important thing to think about in the traders’ risk-management process. Reward/risk ratios vary according to the type of trading strategy a trader uses as well as the markets traded. In general, however, it’s not a good idea to have a ratio below 1:1, because the risk outweighs the potential reward. If this is the case, then the number of winning trades must exceed the number of losing trades for the trader to achieve net profitability. On the other hand, the more that potential reward outweighs risk, the fewer winning trades a trader needs to achieve net profitability. There are successful traders that have a low win percentage but are still profitable due to their high reward/risk ratio. At the same time, it should be kept in mind that traders with higher reward/risk ratios generally have lower win percentages, while traders with lower reward/risk ratios generally have higher win ratios (if all other variables are the same).