Risk management in trading

Risk management is a strategy that involves having traders take certain precautions in order to protect themselves when the market moves against them or if they experience a series of losses. These precautions include limiting the amount of capital a trader uses for every trade. The goal is to keep the remaining funds safe so that if a loss occurs, the trader can afford and recover from it.

Without the necessary discipline and following the rules set out in the risk management plan, traders might struggle to determine when to cut losses. Instead, they might hold onto a losing trade for too long, hoping it would reverse, only for it to wipe out their account.

It could be said that almost every trader experiences losses. However, the overall goal of having a solid risk management plan is to try and keep losses smaller than potential profits. This comes into play with a trader’s risk-reward ratio, but we’ll cover that in more detail later in this article.

As mentioned earlier, there are always risks involved with trading. However, these risks can be categorised into five different types, namely:

• Market risk
• Interest rate risk
• Liquidity risk
• Leverage risk
• Systemic risk

Below is a breakdown of the three types of risks.

Market risk

This is one of the most common risks involved with trading as it directly relates to the fluctuation of market prices for a trader’s chosen financial instrument.

One essential way for traders to mitigate market risk is to better understand what drives the price of their chosen instrument. For example, if you’re looking to trade gold, different factors could influence its price, in addition to supply and demand, such as interest rates and the price of certain forex currencies.

Now, some of these factors influencing the price fluctuations could be easy to spot. However, some might be a bit more unclear, so it might be best to always have a take-profit and stop-loss order in place to protect yourself from those quick, unforeseen price changes.

Interest rate risk

A country’s central bank’s decision to increase or decrease interest rates could affect the overall value of its currency.

This decision could also bring about a certain level of volatility in the market, which could cause fast and frequent price fluctuations for specific financial instruments such as forex pairs and commodities.

Liquidity risk

Some financial instruments have higher liquidity because of the higher supply and demand for them. This means that when trading those instruments, your trades are executed quicker.

Conversely, instruments with lower liquidity don’t have the same degree of supply and demand, which means a trade could take longer to execute. 

The risk factor comes into play when trading a lower liquidity instrument, and you might want to get out when the market starts moving against you; however, because the trade takes longer to be executed, you might get out at a worse price than you initially wanted, which means the loss could also be bigger.

Leverage risk

You can trade on margin with leverage through derivative products such as CFDs. This means you can open a bigger position with only a small amount of investment capital.

Trading with leverage magnifies potential profits because the trade results are calculated based on the entire value of the position, not just the initial margin amount used to open the position.

When a trade starts moving against you, the risk aspect comes in because losses are also magnified through leverage trading. So, without a proper risk management strategy, that trade could wipe out your entire account, depending on how strong the trade moves against you.

Systemic risk

Systemic risk involves a much bigger issue that affects the broader financial system and, in turn, could harm your investments. A global economic crisis is one of the most common examples of systemic risks.

When a global financial crisis happens, world banks could freeze all bank reserves, and interest rates would drop dramatically, severely impacting markets such as the foreign exchange market. Unlike other risks, which generally only affect a particular market or a specific company/industry, systemic risks could affect the entire economy of a country or multiple countries.

This is why systemic risks could severely impact investments. To protect yourself from such risks, it could be beneficial to have stop-loss orders in place on all open trades and monitor important news and economic events.

There are various insights you could potentially incorporate into your risk management strategy. So, we’ve compiled a list of eight risk management insights with detailed descriptions of each to help you better understand their significance.

Set up a risk-reward ratio

As previously mentioned, all trading involves risk, so it might be best to determine the level of risk you are willing to take before entering a trade. This comes down to your risk-reward ratio, the amount of money you are willing to lose compared to the amount of profit you might want to make.

Generally, most traders won’t risk more than 1-2% of their capital for each trade and no more than 5% across all their open positions.

For example, let’s say you have a risk-reward ratio of 2:1 with a $1000 account; this means you are willing to lose $10 in order to make $20 per trade. Placing a predetermined stop-loss order could assist in limiting your loss to only $10 if and when the market starts moving against you.

Use stop-loss and take profit orders

A stop-loss order is a type of order used to protect you from any substantial losses when the market moves against you. It works by setting the stop-loss order at a predetermined level. When the market moves against your prediction and hits the stop-loss order, the position automatically closes, protecting your account from further losses.

Now, a take-profit order is just the opposite; it is a type of order set at a predetermined level to secure any potential profits when the market moves in your favour. It works like the stop-loss order, except when the market moves in your favour and touches the take-profit order, the position will automatically close, securing any profits made.

The actual level at which you place your stop-loss and take profit order will depend on your risk-reward ratio.

The orders will be calculated by the amount of pips the market has to move in your favour or against you to get your risk-reward ratio. For example, if you have a ratio of 2:1 and you set the take profit order 40 pips above the entry price, the stop-loss order would be half that distance at 20 pips below the entry price.

Having a solid trading plan

A trading plan - such as a forex trading plan if you decide to trade the forex market - can be seen as your personal decision-making tool, which could assist you in staying disciplined to avoid having your emotions involved in trading decisions.

A trading plan is personal to each trader. It could include factors such as your trading goals, strategy, risk-reward ratio, risk management plan, financial instruments, time available to spend in front of the charts, and when to enter and exit a trade.

In addition, it serves as your trading diary, allowing you to record all your trades—both winning and losing. This helps you analyse what worked and what didn’t and make adjustments to improve your approach as you refine your trading skills.

Managing leverage

We already covered how trading on margin through leverage works earlier in this article and the potential risks it could entail, which is why placing a stop-loss order in every position is an essential factor to try and prevent any substantial losses from occurring if and when the market does move against you.

For example, if you were trading the forex market and decided to open a long (buy) position on EUR/USD of $100,000 at a leverage ratio of 20:1, you’d need $5,000 to open that position. Now, if the price of EUR/USD increased by 5%, you’d make a profit of $5,000; however, if the market decreased by 5%, you’d lose $5,000.

It might be essential to remember that with a higher leverage ratio comes higher risk.

Indicators to assist in placing stop-losses

Technical indicators aren’t just tools used in technical analysis to look for potential entry and exit points; they could also be used to indicate where to place a possible stop-loss order. Let’s take a look at three different indicators which could be used to provide you with a better indication of where to place a stop-loss order.

Average True Range (ATR)

This indicator measures the average pip movement of a financial instrument over a specific period. It provides traders with information on where to place their stop-loss orders for their current position based on the highest point the ATR reached during a particular session. 

The way to use the ATR to determine the possible stop-loss position is by taking the ATR value at the candle you’re looking to enter the position and multiplying it by two. You’d then take that result and subtract it from the entry price. 

For example, if you’re looking at the picture below, the ATR value is at 0.00202, and the entry point is at 0.66116. 

The calculation will be 0.00202 x 2 = 0.00404; now, you’d take 0.66116 - 0.00404 = 0.65712 to get the stop-loss level.

Moving averages

Moving averages could indicate possible entry points and where a possible stop-loss order could be placed.

In theory, when the moving average, let’s say the 50 moving average, is above the price, the market is considered bearish. A trader looking to enter a short (sell) position could place their stop-loss order some distance above the moving average.

If the 50 moving average is below the price, the opposite is true, and traders could place their stop-loss order some distance below the moving average when looking to enter a long (buy) position.

Support and resistance

When the market is range-bound, and traders use support and resistance levels as indicators to look for possible trading opportunities, they could also use these levels to place stop-loss orders.

So, if the price is at resistance and a trader is looking to enter a short (sell) position, they could place their stop-loss some distance above resistance.

The same is true when the price is at support, and a trader is looking to enter a long (buy) position; they could place their stop-loss order some distance below support.

Managing emotional state

There are many different emotions that could get in the way of making calculated trading decisions; this could be true when you make a profit or a loss.

Emotions such as greed, fear, anxiety, temptation, or doubt could negatively affect your decision-making process, which could result in overtrading or revenge trading.

Overtrading refers to a trader opening a large number of positions simultaneously without considering their trading plan or decision-making process.

Revenge trading refers to a trader suffering substantial losses and wanting to return that money, so they open multiple positions without considering their trading plan and strategy.

Some traders become overly stubborn and might not want to exit a trade when they should, believing their losing position might turn around, which could possibly end up getting worse.

As previously mentioned, having a trading plan to act as your decision-making ally could prevent these emotions from clouding your judgment in either of these cases.

Keeping an eye on economic and news events

Making predictions about the price movements of any financial instrument could be difficult, as many factors influence the price movements of the instrument you might be looking to trade.

This is why many traders might use fundamental analysis within their trading, including important economic and news events that could significantly influence price movements, trying not to get caught off guard.

Portfolio diversification

We’ve all heard the expression, “Don’t put all your eggs into one basket.” Trading is no different. By diversifying your portfolio, one profitable position could potentially compensate for another losing position.

By diversifying your portfolio across multiple financial instruments and markets, you can mitigate risk-offsetting potential losses in one market with gains in another that move in your favour.

A stop-loss order is one of the most popular risk management tools traders can use. There are three different types of stop-loss orders; below is a detailed breakdown of each.

Normal stop-loss

As explained in the previous section, this standard stop-loss order will close automatically when the price reaches the predetermined level the trader sets. Unfortunately, it won’t protect against slippage.

Slippage happens when the market gaps and there is a significant difference between the previous candle’s closing price and the next candle’s opening price. But that’s not the only way slippage can occur; it can also occur within a single candle and within a single second.

Slippage occurs between two ticks, with your stop-loss between the price of those two ticks. During volatile moments, we can get several ticks per second; hence, you can have slippage within a single candle, even those of one minute and one second. 

When slippage occurs, a stop-loss order will probably be triggered at a price worse than the predetermined level due to the price gap. However, there’s also the chance it might not be triggered depending on how quickly the market moves.

Guaranteed stop-loss

This type of stop-loss order eliminates the issue of slippage, as a broker will honour the exact predetermined level set by the trader. However, a broker may charge a small percentage fee to guarantee this stop-loss order.

Trailing stop-loss

A trailing stop order is a type of stop-loss order that moves closer to the current price while maintaining the distance of the initial predetermined level as the market moves in the trader’s predicted direction.
When the market moves against a trader’s position, and the stop-loss order is triggered, the overall position could still be closed in profits, depending on how far the market moved in their favour before the stop-loss order was triggered.

Risk management and money management go hand in hand as they form part of your risk management strategy. However, they focus on different factors in how to manage your trading capital.

Risk management focuses on protecting our investment capital from potential losses. This involves different strategies to minimise the possible losses from each, which could occur by setting stop-loss orders, limiting the size of a position, and diversifying your portfolio.

The overall goal of a risk management strategy is to safeguard investment capital while protecting your account from significant losses.

Conversely, money management involves how much your risk capital will be per trade, which is the money you could afford to lose without affecting you emotionally or financially. It also involves how much capital you might want to use per trade, the percentage of risk allocated per trade, and your risk-reward ratio.

The overall goal of money management is to try and minimise losses while trying to maximise profits.

Risk management is an essential part of trading for various reasons. As we've mentioned previously, risk is always involved when trading in financial markets.

Having a solid risk management strategy could assist you in safeguarding your investment capital by limiting the amount of funds you choose to risk per trade, as well as using different risk management tools such as stop-loss order to potentially prevent any significant losses to be obtained when the market moves against you.

Another reason a risk management strategy might be essential is to provide you with a set of rules and guidelines to potentially reduce emotional stress levels and make more rational trading decisions instead of trading based on emotional impulses.

By following these rules and guidelines, together with the entire risk management strategy, it could ultimately assist in protecting your investment capital from the ever-present market uncertainty and unexpected economic and news events that could lead to significant price fluctuations.