Trading Risk Management - Best Strategies for Limiting Losses
Trading is a game of risk and return. The balance between them determines your trading style and your chance of success. Herein lies the main problem.
The first question on a beginner trader’s mind is how much can I earn on this trade. This wrong behavior. It should always be How much can I lose? Managing trading risk helps maximize your potential gains while also minimizing potential losses.
In this guide, we will discover what trading risk management is. We will also examine how it can help you grow in your trading career. Finally, we will go over the best tools for this. let’s start!
What is trading risk management?
Trading risk management is a comprehensive strategy for minimizing your losses and protecting your trading account capital. It is an invaluable tool in any successful trader’s arsenal and the foundation for building a successful trading plan. It is also a must-have for every hedge fund, trading firm, or high-volume investor.
Risk management is basically a view that takes into account everything that can go wrong while trading. It looks at what could make your capital vulnerable to losses. It tells you how to proceed in each situation to better protect your assets. If trading is a house, risk management is its foundation. It determines how successful your trading strategy will be. This helps you determine whether you will be able to survive in the current competitive environment of financial markets
Trading risk management is not just about losses. It also sets a reasonable profit target that you should aim for without worrying about the stability of your portfolio. It is also essential for market participants looking to invest in a particular capital, for example. Among the basic tools that help them find the optimal investment opportunity is the so-called Sharpe ratio. This helps investors understand the return on investment compared to its risk. Rather than – how effective is the risk management strategy for funds. A high Sharpe ratio is preferred as this means that the funds have been able to generate good returns without taking excessive risks
Why is trading risk management important?
Risk management is important because knowing when to trade and when to close your positions will determine your long-term success. Many traders start from the idea that winning is more important than losing. Alternatively, if your winnings outnumber your losses, no matter how big they are, you will succeed.
However, this in and of itself is not viable in the long run. If you look at the most successful examples from the world of trading and investment, it is the people and institutions who got to the level they reached by carefully evaluating their options and only opening a trade at the right opportunity. This kind of achievement takes many years or even decades
How to manage trading risks?
A way to manage trading risk is to identify as many risk factors as possible that may affect the health of your portfolio before you start trading.
This cannot be overstated. By identifying all potential threats to your investments, you will be prepared for most that can go wrong and will put together a backup plan. Knowing how to act in these situations will help you stay calm and keep your emotions in check even in the heat of the moment. It will give you confidence to know that your strategy is based on well researched and thoroughly tested information. Let’s illustrate this with another example. Suppose you are a futures trader who wants to specialize in energy commodities. To build the foundation for your trading risk management strategy, you will consider the many factors that affect price, including, but not limited to:
Market details: Considering seasonality, demand may increase during the winter or decrease during the summer.
Political Risk: Find out where these goods are produced and who the biggest consumers are. Be careful about international restrictions or import/export deals that could disrupt the market trends in the markets
Competitors: If you are trading futures contracts for fossil fuels such as crude oil, keep an eye on renewable markets. Any developments there affect the prices of traditional energy commodities.
Black Swan: Even though you can’t prepare for these events, find out how the market you’re interested in has performed in the past around situations like the covid-19 pandemic, oil spill somewhere around the world, etcetera.
Intraday Trading Factors: Find out how these commodities behave when the leading markets are open and closed. Study their reaction to surprising upcoming news to know what to expect when the markets open. Of course, there are a lot of other factors that you should take into consideration and prepare for, but this is a good start. Be sure to expand this list with all known risks and threats that may affect the price of the asset you are interested in Once you have completed this step, it is time to be more practical and learn how to plan your trades
Plan your deals
Take as much time as you need to plan your trades and become confident in your strategy. Make sure you test it with paper trading first to check for vulnerabilities and fix them without risking your real capital. (Every battle is won before it is fought) – Sun Tzu The phrase “plan to trade and plan to trade” basically sums up what most beginners should do. Although they are self-explanatory, they are not necessarily easy to apply in real life. First, think about your trading style and plans for your repeat trades. Figure out if you’re going to make two trades a day or one a week, for example
This is necessary because it will determine how your strategy works and what risk management factors it should include. Also, you should find a broker that is suitable for your trading style and needs. When you are a day trader, you will be looking for a broker with low trading fees. If you are an investor in alternative assets, you will be looking for a broker that has a wide range of exotic product offerings.
If you are a beginner with limited capital, you may want to start with a service provider that provides investment opportunities without commission. The most demanding traders will look for brokers with popular platforms and rich analysis features. Once you are ready to go, make sure you plan out your profit targets and the rules your strategy must adhere to. Instead, make a plan of when, where, what and how to trade. The rules you establish will be the bedrock of your strategy
The one percent rule
The 1% rule suggests that you should never put more than 1% of your capital into a single trade. It ensures that you make reasonable trades without risking too much while chasing big profits
That cotton trade was almost a deal breaker for me. At that moment I said, stupid master, why would you risk everything in one deal? Why not make your life a pursuit of happiness instead of pain? – Paul Tudor Jones
Although this idea seems reasonable, you would be surprised how many traders fail to stick to it. The reason is that, many times, we spot an opportunity that looks profitable, and we try to capitalize on our potential returns. However, it may only take one instance where the market proves us wrong to eliminate us.
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According to the one percent rule, if you have $1,000 in your account, you should not put more than $10 per position. The key to making a profit when applying the one percent rule lies in the number of winning trades, not their individual amount. For example, aim for 5 winning trades where you risk 1% on each position, rather than 1 winning trade where you risk 5% of your capital.
In the long run, this has better chances of taking profits and preventing large losses from occurring. Some traders modify this rule by increasing its high limit to 2%. However, this is usually not recommended if you are a beginner or a trader who is still building and testing his or her risk management strategy. The idea of position sizing is simple, never risk too much capital in one trade.
Use stop loss limits
Some traders compare stop-loss limits to owning a life jacket or safety net. The idea is that when you set a stop loss limit, you will be able to control how much you are likely to lose on any trade. Stop-loss limits are applied through specific orders to set up a mechanism to sell your assets once they reach a certain price level. If the price of the instrument remains above it, the stop loss will not be triggered, and your position will remain open. With stop-loss limits, traders can automatically close out positions when the market turns against them.
In this way, they can prevent losing more than they are prepared for. By incorporating stop-loss limits into your trading strategy, you ensure peace of mind even if you cannot monitor the market 24/7. To take advantage of stop-loss limits, you must specify the price at which you wish to sell.
Alternatively, how much loss are you willing to take before closing out your position to prevent further capital loss being inevitable. A stop-loss order benefits every market participant, from the speculator and day trader to the long-term investor
It helps protect against sudden high volatility, black swan events, news-driven market downturns, and other unexpected scenarios by mitigating your losses. However, they can also be used to generate profits. This is especially important when you’re dealing with something like a post-rollback. In this case, unrealized profits can turn into a liability. With that in mind, let’s move on to the next point
Use of T/P Take Profit orders
Make sure to set the T/P Take Profit points at the price you want to close your position and take profit. If the specified price level is not reached, these Take Profit orders will not be triggered, which are very similar to Stop Loss orders in the sense that they allow you to close your position when pre-determined conditions are met.
The main benefit of take profit orders is that a trader will not have to worry about their unrealized profits suddenly turning into a liability when trading an overdrafted account. Thanks to this, you can feel comfortable not watching the market 24/7, knowing that the Take Profit order will close your position if the price level is reached.
Take profit orders are often used in combination with stop loss orders. In this way, the trader can ensure complete control over his positions. They are able to maintain the performance of their investments within certain limits. If the price of the instrument falls below the stop-loss level, the position will be closed, and the trader will cut his losses. On the other hand, if the price suddenly rises above the take profit level, the trader can still push back the pullback.
Take profit orders are mostly used by short term traders and speculators who have to time their moves perfectly.
Determine the risk-reward ratio
The risk-reward ratio tells you what reward you can expect for every dollar you risk in an investment. For example, if your risk-reward ratio is 1:3, you can expect to win $3 for every $1 you risk. We used this particular number because, in general, about 1:3 is actually the optimal and most reasonable risk-reward ratio.
Instead – one unit of risk should guarantee three units of return. However, this can depend on the trading strategy and the trader’s willingness to take risks. You can also look at it as the difference between the market price and limit orders placed at profit and loss levels on both sides. Traders use the ratio to see the best opportunities in the market. A well-defined risk-reward ratio means that the trader knows what to expect from a particular trade even before it happens
Other trading risk management techniques
Trading risk management is almost an entire field of study in itself. There are hundreds of basic books on the subject, and most traders spend their entire careers trying to master efficient risk handling.
Understandably, we cannot cover everything in this guide, as there are some other building blocks for efficient risk management. First, let’s take a minute to reflect on the importance of sticking to the principles of your trading strategy.
In other words, to control your emotions and not overextend yourself in chasing trades that may only seem rewarding. Even if luck is on your side now and then, you will regret letting your emotions take over in the long run. Never forget that you have a reason to use your strategy, and going against it is like walking down an open road blindfolded.
Use of paper trading
Also, it is always essential to test your risk management strategy with paper trading first. This is your training ground, and if you fail to get there, it will be a complete disaster when you go live. However, the difference is that in the latter scenario, you will not have a safety net, and a failed risk management strategy will cost you money.
Of course, don’t rush into leveraged trading before you have at least some experience under your belt. As tempting as it may be, if not managed carefully, and if not backed up with enough knowledge, it could wipe out your capital in mere minutes.
Also, be sure to keep a trading journal containing records of your trading history. This trading data will contain many valuable insights for you to analyze.
Keeping a trading journal will help you to review your past trades and check how and why they worked that way, what you did right, and what you could improve. Developing a directional attitude will make you a better trader.
How can you improve the use of trading risk management strategies?
There are no statistics or data that can determine the exact answer to this question, but to help paint the difference, let’s say that trading without a risk management strategy is not trading at all. It’s like playing roulette. Do casino players have a risk management strategy? What about those who bet on football matches? Some do, but in most cases, they don’t. They may recognize some patterns and make some educated guesses, but the rest is just luck
The difference between a trader who has a risk management strategy in place and one without is night and day. The truth is that no trader without a proper risk management strategy can survive the harsh environment of the financial markets in the long run
“Throughout my financial career, I have constantly witnessed examples of other people who I knew ruined me because of a lack of respect for risk. If you don’t take a sharp look at the risks, they will take you.” Larry Height
Having a risk management strategy puts some control of your positions back into your hands. Without it, you are simply relying on the market to turn in your favor which is rare.
Considering that even traders with decades of experience or companies with risk management departments full of finance gurus and economists with PhDs can’t always predict how much the market will be beaten, the chance that a trader without any strategy in place will be able to do so is practically 0 %
Given the complexity of financial markets, even risk management strategies do not guarantee 100% success. With that said, they give you the best chance of success and ensure that you’ve done everything you can to best protect your investment
The difference between a good and a bad risk manager
The main difference between a good and a bad risk manager is consistency. To ensure more stable returns, a successful trader does not neglect his risk management strategy and often looks for ways to improve it. On the other hand, a trader who fails may go against the plan and put his capital at risk.
Of course, there are many other fundamental differences. Some of them include: He can get carried away with little winning deals and overestimate his capabilities
Closing thoughts
Trading risk management is a fascinating, deep and challenging practice. It takes a lot of hard work, effort, and experience to achieve mastery, but in the end, it’s the same with everything else in life and trading together. If you don’t have the time to do your research and invest in learning and improving risk management techniques, you’d better stay on the sidelines.
If you want to become a successful trader, there are no short cuts, you need a sound risk management strategy in order to protect your capital and ensure the sustainable accumulation of steady profits.
In the end, just know that every minute and every bit of effort invested is worth it because the thrill of success in the markets is like nothing else.
