Every trader knows that risk is part of the game, and what separates the pros from the rookies is how they handle it. Trading without a plan for managing risk is like driving without a steering wheel: Sure, you can get moving, but you’re bound to crash sooner rather than later. Low latency trading and Trading risk management isn’t just about avoiding losses. It’s about creating a sustainable approach to trading that allows you to protect your capital and achieve consistent profits over time. In this article, we’ll share effective strategies for managing risk in trading so you can improve your chances of success and keep your emotions in check.
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What is Trading Risk Management and its Importance
Trading risk management refers to identifying, analyzing, and mitigating risks that can negatively affect a trader’s portfolio. It is essential for preserving capital, optimizing returns, and managing the emotional aspects of trading. Risk management helps traders make informed decisions, reduces the potential for significant losses, and ensures long-term success in volatile markets.
Automatic trading systems can significantly aid risk management by incorporating pre-defined risk parameters into trading decisions, removing emotional factors from the trading process.
Fact: 40% of day traders quit their field within the first month due to losses.
Risk is prevalent in every trade, whether you’re a day trader or a scalper. There are practical and effective ways to minimize these risks and safeguard your investments. It all begins with incorporating reliable risk management strategies into your trading approach.
What is Risk Management?
Risk management involves limiting your positions so that if a big market move or large string of consecutive losses does happen, your overall loss will be something you can reasonably afford. It also aims to leave enough of your trading funds intact so that you can recover the losses through profitable trading within a reasonable timeframe.
Risk management measures the size of your potential losses against the original profit potential on each new position within the financial marketsto succeed as a trader. Without a disciplined attitude to risk and reward, it is easy to fall into the trap of holding losing positions for too long. Hoping things will turn around before eventually closing out for a large loss makes little sense if your original objective was to make a small profit over a few hours.
Long-term trading profit can be described as a winning combination of:
- The number of profitable trades compared with the number of losing trades
- The average value of profits on each trade compared with the average value of losses
It is important to combine these ratios and the relationship between risk and reward. For example, many successful traders have more losing than winning trades, but they make money because the average size of each loss is smaller than their average profit. Others have a moderately average profit value compared to losses but a relatively high percentage of winning positions.
Why is Risk Management Important in Trading?
Experienced traders know that even trading strategies that have been successful over the long term can leave you vulnerable to risks in the short- to medium-term, including:
- Significant runs of consecutive losses
- Occasional large losses where prices gap through stop loss levels, for example, due to a major news event
- Changes in market circumstances mean that you can never be certain that just because a strategy has worked in the past, it will continue to work in the future
Without appropriate risk management, events like this can lead to:
- Loss of all your trading capital or more
- Losses that are too large given your overall financial position
- Having to close positions in your account at the wrong time because you don’t have enough liquid funds available to cover margin
- The need for an extended period of profitable and prudent trading just to recover your losses and restore your trading capital to its original level
The above scenarios can still arise even after using the appropriate risk management strategies. Losing more than 30% of your account can lead to a major task just to recover what you have lost. After large losses, some traders resort to taking even greater risks, which can lead to ever-deepening difficulties.
The Importance of Risk Management for Long-Term Trading Success
To benefit from a winning strategy over the long term, you need to be positioned to keep trading. With poor risk management, the inevitable large market move or short-term string of losses may bring your trading to a halt. As a trader, you can’t avoid risk, but you must preserve capital to make money.
A risk-managed approach to trading recognizes that you are taking risk but must limit that risk in the short term to maximize longer-term opportunities. Lack of risk management is one of the most common reasons for failure.
How Does Risk Management Benefit Short-Term Traders?
Risk management differs for short-term traders, swing traders, and long-term investors. Your approach’s time window will determine the metrics you use to build your risk management strategy.
Short-term traders should aim for a balanced risk management strategy optimized for intraday price movement. It brings a host of benefits, including:
Capital Preservation
First and foremost, a balanced risk management strategy helps you to maintain your available capital or buying power. In prop trading, you earn buying power based on the success of past trades.
Buying power isn’t the same as cash in the bank because it’s the firm’s money you can use in short-term trading activities. The effectiveness of your risk management approach will determine whether the prop firm increases or reduces your buying power.
Improved Profitability
At a high level, you want to execute more winning trades than losing trades. But a pure win-loss ratio or batting average won’t tell the whole story. Balanced risk management for traders means tuning your trades to deliver positive profitability.
If you make three trades, it could look like this:
- Bought 100 shares of ACME Anvils Inc. at $5.06 a share: total cost $506. Sold at $4.56 (a loss of 10% or $50).
- Bought 50 shares of Big Pop Dynamite LLC. at $10.35 a share: total cost $517.50. Sold at $10.75 (a gain of 3.7% or $20)
- Bought 200 shares of Screwy Tools Co. at $2.01 a share: total cost $402. Sold at $2.26 (a gain of 12% or $50)
Your win-loss ratio is 2:1, but your percentage gain is only 5.7%, and your total profitability is just $20.
As you develop your risk management plan, you can begin to plan specific trades around your success metrics. In some cases, a large trade with a smaller price movement could compensate for a minor trade with a much larger price movement and lost money.
Regulated Emotions
Trading is about math, statistics, risk, and reward. But it’s also about the psychology and emotions of thousands of other traders working toward their goals. Human emotions can be beautiful and terrifying. The science of risk management allows you to build guardrails that can prevent impulsive deviations from your original plan.
You may need help to honor the limits you set for trading activity. Part of you will leap at the possibility of a trade breaking out and earning you a major win, even if the odds aren’t strong. Complying with your risk management parameters allows you to protect against these urges. To put it bluntly, emotion-driven traders don’t make good career traders.
Adaptability
The best risk management strategy can be adjusted (within reason) based on market conditions and shifting priorities. Your strategy shouldn’t be too loose, but it can’t be too tight. A wise trader has the experience to know when to adapt risk tolerances and how much to adjust them.
Nobody is born with this knowledge; it’s only earned through trial and error. Make live trades with real money and then analyze your behavior. Look for inconsistencies or moments when things didn’t go as planned.
Improved Leverage
Leveraged trading is an advanced strategy that requires traders to have a sophisticated understanding of risk management. In short, a leveraged trade is where you can use a small amount of capital to execute a much larger trade.
For example, your broker might allow you to put up only $5 of capital for a $50 trade and loan you the remaining $45. Leverage cuts both ways, delivering astonishing gains and devastating losses. As such, it must be backed by a deep understanding of the risk to your portfolio. As you build up a track record of successful trades using standard buying power, you move closer and closer to earning the right to make leveraged trades.
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10+ Common Trading Risk Management Strategies
1. Risk-Reward Ratio: A Simple Method to Control Risk
Calculating a risk-reward ratio for your trades can help determine if a potential position is worth the risk before entering. In the simplest terms, the formula for calculating the risk-reward ratio for a trade is potential loss / potential gain. If you invest $1 and expect the trade to return $2, your risk-reward ratio is 1:2.
How you calculate the potential gain of a trade is subjective.
Using concepts such as price support and price resistance will help you make realistic projections about return, but there isn’t a foolproof method. It may seem obvious, but you only risk the money you put in in most trades: invest $1, and you can only lose $1.In a leveraged trade, you stand to lose the money you invest plus the money you borrowed from the broker to execute the trade. A commonly recommended risk-reward ratio for short-term traders is 1:2.
2. Stop-Loss Orders: Limit Your Losses
This is one of the most critical tools for short-term traders to understand. A stop-loss order is a set of instructions a trader gives to sell an asset if the price falls to a specified level.
Let’s take one of the trade examples from earlier.
If you bought 100 shares of ACME Anvils Inc. at $5.06 a share and set a stop-loss order at $4.81 (or 5%), then your upfront cost would still be $506, but you would have automatically sold the stock at $4.81 and only lost $25.Using a stop-loss order lowers your risk far below your investment baseline. While setting your stop-loss order under 10% is a good starting point, you should know that many traders use 3%-8% stop-loss orders as a standard.
As you gain experience with this risk management tool, consider using a trailing stop order. Unlike the fixed standard, this one moves by the stock, preventing you from constantly adjusting it.
3. Avoid Slippage
It is important to know that stops may be filled at a worse price than the level set in the order. Any difference between the execution price and stop level is known as slippage. The risk of slippage means that a stop-loss order cannot guarantee that your loss will be limited to a certain amount.
We also offer guaranteed stop-loss orders (GSLOs), which are an effective way of safeguarding your trades against slippage or gapping during periods of high volatility. A GSLO guarantees to close your trade at the price you specified for a premium. We refund this charge if your GSLO is not triggered on your trade. Find out more about our range of trading order types and execution.
Understanding Slippage and Its Impact on Stop-Loss Orders in Trading
One common reason for slippage is price gaps in response to a major news event. For example, you may set a stop loss at $10.00 on XYZ company CFDs when trading at $10.50. If XYZ company announces a profit downgrade and the price falls to $9.50 before trading again, your stop-loss order will be triggered because the price has fallen below $10.00. It becomes a market order and is sold at the next available price. If the first price at which your volume can be executed is $9.48, your sell order would be executed at that price. In this case you would suffer a slippage of 52 cents per CFD.
Slippage is particularly common in shares because markets close overnight. It is not uncommon for shares to open quite a bit higher or lower than the previous day’s price, making slippage easy on stop-loss orders. Slippage can also occur when insufficient volume fills your stop order at the nominated price.
4. Diversification and Correlation: Don’t Put All Your Eggs in One Basket
Diversification is beneficial if you take the time to evaluate the various risks and correlations for each position. For example, it would not be wise to choose companies that a large oil price increase, such as plastics and global shipping would negatively impact.
Consider investing in the best companies across all sectors, such as finance, technology, healthcare, and utilities. This could mean placing a buy trade on companies like Tesla, Nvidia, and Google, as these companies often work well when the economy is in good health. These stocks will often decline when the market retreats. A popular approach to risk diversification is to focus on ETFs (exchange-traded funds), which are baskets of securities you buy a portion of the same way you can buy stock in a company. Essentially, you’re relying on someone else to create a diverse pool of investments.
5. Overnight Trades: Why It’s Best to Avoid Holding Positions Overnight
Holding a trade overnight is usually a bad idea for short-term traders. Swing traders often hold assets for multiple days, while long-term investors hold them for months or years. Each type of trader develops risk management techniques that fit their portfolio and overall strategy.
Short-term investing is predicated on a strategy where the trader closely monitors each open position and responds to real-time price action. The risk management plan for a short-term trader should ensure that all trades are closed in the overnight session. The benefit of doing this is that it protects you from sudden events when you cannot trade.
6. Size Your Trades: Keep Your Position Small
You should always have the size of your open trades written down. In all trades, you should always ensure that you risk only a small portion of your account. In other words, you should risk a slight portion of your account in all trades that you do.
Do you recall the earlier example of the three trades, in which one person lost money and two made money?
- Let’s say all those trades were open at the same time. That would mean your open positions would be equal to $1,425.50.
- Let’s say your total buying power is $20,000, which means my total portfolio risk is 7%. As a general rule, limiting your potential drawdown to less than 20% of your buying power is a good idea.
It might sound simple enough to limit your open positions, but if you’re watching a trend develop, the temptation to re-enter the market will be strong. You might want to take two or three positions on the same stock. How will each position affect my individual position risk and portfolio risk?
7. Value at Risk (VaR): A Statistical Approach to Risk Management
Despite the seemingly obvious name, VaR is derived from a statistical model that quantifies the potential for loss in a security over a given time frame.
It’s usually expressed with two percentages and the time frame assessed. For example, an asset with a 5% 60-day VaR of 20% has a 5% chance of declining in value by 20% over two months. VaR is computed by one of three statistical models. Although the example we gave is a long time horizon, VaR is a valuable risk management tool for short-term traders.
8. Scenario Analysis: Assessing Portfolio Risk Under Varying Conditions
Scenario analysis is another strategy that allows you to assess how the value of a portfolio might shift over time based on a series of “what if” situations.
Scenario analysis allows you to analyze your portfolio across various events, including highly likely or unlikely events. This can allow you to evaluate how those outcomes pair with your risk appetite and management strategy so that you can adjust accordingly. A popular type of scenario analysis is stress testing, where you evaluate the performance of your portfolio against extreme or unusual market conditions, sometimes referred to as black swan events.
9. Two-Day Low Strategy: A Method for Placing Stop-Loss Orders
The two-day low strategy is where a trader puts a stop-loss order of 10 pips (or the equivalent) below the two-day low price for the asset. Passing the two-day low is a reasonable indicator of a downward trend.
A pip is a FOREX term that refers to the smallest unit of price change in a currency pair or one-hundredth of one percent (four decimal places). However, the equivalent for other assets would be the most minor change unit.
10. Parabolic Stop and Reverse: A Tool for Placing Stop-Loss Orders
Parabolic stop and reverse (SAR) is a popular technical indicator for determining where to place a stop-loss order. However, it’s also among the most easily confused and misused indicators. Parabolic SAR is only useful with candlestick charts when the market is trending. If used under other conditions, the results will not be a good trading guide.
SAR can confirm which direction an asset is likely to move in. When dots appear above the asset’s price, it’s likely to continue downhill. If the dots appear below the asset, it tells you that its price will likely climb. Due to its complexity and tendency to confuse inexperienced traders, we recommend that you study how SAR works and use it extensively in a trading simulator before you use it in live trading.
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Six Steps to Manage Risk Efficiently
1. Know How Much Risk You Can Handle
Every trader has a tolerance to risk. Trading instructors often recommend risking anywhere from 1% to 5% of the total value of your trading account on any given opportunity. But in truth, you should decide how much you want to risk based on what makes you comfortable. Once you become more comfortable with the system you are using, you may feel the urge to increase your percentage but be cautious not to go too high.
Remember, trading aims to either realize a return or maintain enough to make the next trade. If you’re trading once per day on average and risking 10% of your balance on each trade, it would only theoretically take ten straight losses to drain your trading account completely. On the other hand, if you were to risk 2% on each trade I place, YOU would theoretically have to lose 50 consecutive trades to drain my trading account.
2. Size Your Positions Correctly
Once you know how much to risk on any given trade, you should be able to plan the size of your positions. Getting the right balance here is important. If you’re risking $100 on any trade, trading a standard lot of EUR/USD (100,000 units) probably isn’t a good idea. If the pair drops from 1.1300 to 1.1200, you will already have hit your risk tolerance for the position.
One of the easiest ways to ensure you are getting as close to the amount of money you want to risk on each trade is to customize my position sizes. For example, a standard lot in a currency trade is 100,000 units. On EUR/USD, that represents $10 per pip. Meanwhile, a mini lot is 10,000 units. In the trading world, having the flexibility to take risks when and what you want could determine your success.
3. Determine Your Timing
Unless you’re planning on building or buying a sophisticated trading algorithm, you’ll need to be able to place trades to take advantage of opportunities. Many markets are open 24 hours a day, which means deciding how much time you want to spend trading each day and when you want to do it. This also helps you get in the right mindset for trading, which can help manage risk.
Getting up at 3 a.m. to place a trade won’t necessarily mean I’m making the best decisions. Exit orders are useful for managing risk when you aren’t fully focused on the markets. Some traders also use alerts to notify them when their positions are getting close to their maximum loss or profit target.
4. Avoid Weekend Gaps
Most popular markets close their doors in the US on Friday afternoon (5:00 PM ET). Investors pack up their things for the weekend, and charts worldwide freeze as if prices remain at that level until the next time they can be traded. However, that frozen position doesn’t show the full story. Markets are still moving throughout the weekend and may have moved drastically by the time you can trade them again. As we covered in the Exit orders lesson, these gaps can move markets beyond your stop loss level.
A good risk management plan should outline how you mitigate this risk. Come Friday afternoon, you’ll have the option to close my position. While gaps aren’t necessarily common, they occur and can catch you off guard. As in the illustration below, the gaps can be huge and could jump right over a stop if it was placed somewhere within that gap. To avoid them, you could exit your trade before the weekend hits and perhaps even look to exploit them by using a gap-trading technique.
5. Watch the News
News events can also significantly impact forex markets. Some employment reports, inflation reports, or central bank decisions can create abnormally large moves. Some will even cause a sudden gap in a fully open market and trading.
Just as gaps over the weekend can jump over stops or targets, the same could happen briefly after a major news event. Unless you specifically want to take a strategic risk by placing a trade around the news event, trading after those volatile events requires careful risk management.
6. Make it Affordable
In trading, it’s often said that you should never invest more than you can afford to lose. The reason that it is such a widespread manifesto is that it makes sense. Trading can be risky and difficult, and risking your livelihood due to the varied and difficult-to-predict market dynamics is rarely a good idea. Don’t gamble away your hard-earned trading account: invest it in a way that is intelligent and consistent.
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