Risk Management in Trading
Risk management is not something that can be overlooked. Although nobody opens a trading account with the aim of losing money - certainly not members of Trade Nation - sometimes our trades don’t work out the way we’d like. When this happens it’s important to accept it quickly and close the trade, see where things went wrong and learn from it for next time. The trick is to keep losses small and manageable. So even if you do have a few losing trades, you’ll still have funds available to carry on trading.
Risk capital - money you can afford to lose
Taking losses is a feature of trading. Every time we trade, we take a view on where a market will go over time and even the experts can’t always be right. No matter how much effort we put into our analysis and planning, markets don’t always do what we expect of them. Quite often the factors that moved prices one week won’t be the same a fortnight later. So remember that trading conditions can change quickly. With this in mind, only trade with ‘risk capital’ which is money you can afford to lose. The next stage is to carry out some straightforward money management.
Don’t put all your eggs in one basket. In other words, don’t risk everything on just one or two trades. If these go wrong, then your risk capital is gone, and so has your opportunity to make money from trading. Even worse, you may be tempted to dip into funds which, if you’re honest, you really shouldn’t put at risk. Instead, divide up your risk capital into smaller packages. Some say you shouldn’t risk more than 5% of your risk capital on any one trade. Others say the percentage can be higher, and others much lower. How you make the split will depend on the amount you have to trade as well as your own attitude to risk. Overall the aim is to keep losses small and manageable. Then you can relax and run your winners and look to lock in bigger profits. Doing this consistently over time is the key to successful trading.
Here’s the plan
Nobody likes taking a loss. It’s proof that we got something wrong. But the trick is not to take it personally. Sometimes, a trader will watch as losses build in the hope that prices will eventually reverse direction and prove them ‘right’. Their brains may say one thing, but their hearts pull another way. This is when money management rules fly out the window and losses can be so large that they can wipe out the whole trading account. This can be devastating, both financially and emotionally. For this reason, it’s vitally important to develop and stick to a trading plan. This is a discipline common to all successful traders. Over time it will help you limit your losses, run your profits and build up your capital. A trading plan helps take the emotion out of trading and frees up your decision-making process. It will also help you sleep soundly without worrying about markets moving against you.
How it’s done – charts and analysis
It’s important to plan your trades in advance. Successful traders study the market, so they have a good idea of where they want to open a position and where to get out if prices move against them. They will also have a target for taking a profit. It’s important to consider in advance of profit potential for every trade. There’s nothing more frustrating than seeing a profitable trade turn into a loser by not closing it in time. The vast majority of traders use charts to help them plan their trades. Charts show how prices have moved in the past, and often patterns emerge giving clues to how prices may behave in the future. Traders study chart patterns and use drawing tools, which can be as straightforward as simple horizontal lines, to help them pick out obvious areas of support and resistance.
Prices tend to bounce higher off support and pull back from resistance. Traders use these patterns to identify favourable levels to enter a position and close with a profit, and also where to place a stop-loss order if prices move against them. Some may hold positions for only a short period of time. For instance, day traders never hold a position overnight. But trend traders may keep a position open for weeks or even months. They study charts to identify when markets are trending higher or lower. They then look to trade in the direction of the trend until there’s an obvious change in direction.
The Trade Nation platform has charts for all its financial instruments, together with a large number of technical indicators. These will help you plan your trades, giving you the best opportunity to profit from market moves. And you don’t need to spend all day watching the screen for prices to hit your levels. At Trade Nation it’s easy to set up advance orders to help you plan and execute your trades.
Risk and leverage
Whatever their chosen style, the most successful traders develop a set of rules designed to limit the financial damage of a market moving against them. As we’ve discussed, sticking to rules such as strict money and risk management brings form and discipline to a strategy and helps take the emotion out of trading. This is particularly important for spread trades and Contracts for Differences (CFDs). These are called financial derivatives because they ‘derive’ their prices from an underlying market. That’s the jargon. What this means in practice is that spread trades and CFDs are used to speculate on price movements on all kinds of financial markets. These include an individual company’s share price, stock indices, commodities and currencies. Spread trades and CFDs have certain advantages over some traditional investments. For a start, you can speculate on prices falling just as easily as going up. Also, you trade on margin and use leverage. Again, that’s the jargon. What it means is that you don’t have to put up the whole value of what you want to buy or sell. Instead, you deposit a smaller percentage, or margin, with Trade Nation to speculate on price movements. This gives you leverage. Trading with leverage means your profit potential is magnified, but so are any losses should the markets not go your way. This is why risk management, or limiting these potential losses, is so important.