Risk Management

What is risk management?

Risk management is a key factor in trading. Most successful traders include a risk management strategy into their general trading strategy no matter if they are trading for the first time or they have been trading for 10 years in a row. Responsible traders will manage their risk in a way that partially protects them from unpleasant experiences. But why is this notion so important?

Risk management is the action of lowering the potential loss that can happen to your positions. This can be done in many ways, and it is not all in your hands – it depends on what the company you are trading with offers. Taking into consideration the risk involved in trading, any chance to prevent potential losses should be implemented where possible.

Main concepts which helps you better understand risk management are:
Stops and limits – Use risk management tools to limit losses and keep your profits secure.
Hedging – How you keep to open positions can impact offset risk.
One percent rule – Self-applied rules are able to control your trading and prevent huge losses.
Mentality – Understanding your state of mind which is more productive for you while trading.
Discipline – It stays among the most valuable behaviors that a trader can manifest.

How can you settle a good risk management strategy?
You need to know a couple of things first such as risk management tools, guidelines, trading rules, trading techniques. You need to establish good self-discipline and self-assessment.

Maybe you will need to put some new rules and follow them. For example, following a certain rule like the one percent rule, which can make sure your open positions are not exposing the major part of your available capital into the market.

Managing emotions is also crucial to be successful in risk management. Being unable to manage your emotions and your state of mind will raise the cost of your trading. Your weak state of mind will weaken your ability to conduct the risk analysis of the trades you are going to make. Even though it seems easy to manage emotional stability, it is proven to be difficult.

Let’s say that you are dealing with a loss, or a profit, if you are not strong enough to not let your emotions direct your next actions, it will be difficult for you to be profitable in the long run. If you close a position to get the profits, it is not a good idea to immediately re-enter the market with more capital to invest. Not two trades are the same so do not open/close trades because of the others. Good traders would resist the temptation and enter the markets when it seems right to do so.

Stops and Limits
What are stops and limits?

Stop loss and take profit orders are risk management tools that are able to automatically open a new position or close an existing one at a predefined price level. Stops, as per their name, are set to close existing open positions. The limit price is set at the trader’s choice, below the current price of the chosen asset. If the price of this asset falls to that level, the position will be automatically closed. This is applied to minimize the amount of capital you lose on a trade if the market goes in the opposite direction of what you thought.

On the other side, a take profit order is also predefined and plays the same role as stop loss order. It will be automatically closed once the predefined price is met. It serves to protect the profits, to get the maximum of the profits at the price you decided according to your previous analysis.

What is hedging?

Hedging refers to the action of opening a new position that is the opposite of the current one. For example, if there is a short position open in EUR/USD, hedging would mean you open a long position in the same currency pair. It does not always play a positive role, because it happens to cut the profits. The purpose of hedging is to cut the potential losses, but as it seems it cuts the profits also.

There are two reasons for hedging a position. First, protect an open trade from a sudden price change. Second, take advantage of a price change in the short term, which goes against the current open position.

One percent rule
What is the one percent rule?

This rule is a form of capital management that ensures only a portion of your available capital is at risk at one time per position. Following its logic, it either means limiting the amount of capital invested in only 1 % of your account’s total funds or using stop losses orders, which are set in a way that the loss on a position cannot go larger than 1% of funds. Let’s suppose, you have $ 10,000 available in your account to trade. The one percent rule would mean the maximum amount of capital you should open your trades with is $100. If a company is trading its shares at a price of 100, you would be able to open a position at $1 a trade.

The purpose behind this rule tends to be protective toward the trader’s capital. In that case of the market going completely in the opposite direction of your trade (at a moment it will happen), only a small proportion of the total capital is lost. A trader who applies this rule might have 99 positions which have gone bad, they still have capital in their account to trade, because of the 1 % of their original funds.

You need to master emotional control before getting too much into the trading. Your emotions are able to ruin everything. Have the correct frame of mind when placing trades, to be sure that you will not react, instead you will make cold-blooded decisions. Trading while upset, angry is not in your interest at all. Another mistake is chasing trades or keeping a position open hoping it will be profitable. Losing trades should not keep open just for the sake of ‘maybe it turns out to be profitable’.

If loss occurs, accept the situation and move on. Every trader, specifically beginner ones suffer losses, but the smart ones do not let the loss of a moment affect future judgement or guide future actions.
You should never open a position when you are sad, angry, upset; when you haven’t calculated the possible losses and how much can you afford; when you do not know the asset and its nature; when you are obsessed with losing trades; when you are trading only to kill time.

Discipline is an aspect you very much need to focus on. Discipline comes along with mentality and it refers to not only losing trades, but also opening new ones. Always perform technical and fundamental analysis before opening a position. You will regret only if you do not do so. When a trade is doing well, it is collecting profits, at some point the market will start to fall. You need to not be greedy and keep the position open. Close it at the right time, so maximize the profits. It is rare to perform this action, at exactly the right time but do it closely enough even though you will undercut a small amount of value.