In this article
Here at Trade Nation we cannot overestimate the importance of risk management. And the cornerstone of risk management is building a trading plan. So, we thought we’d save you some time and effort by putting down our views on both why it’s so important, and also what should be in it.
Having a plan is like reading a map before starting a journey. It will help you get to your destination. There’s nothing to stop you setting off without knowing your route. But it does make life a lot harder. In contrast, a plan provides a framework to help you identify which markets to trade, when to take profits and when to cut your losses. It instils discipline and so helps take emotion out of trading. Once discipline is lost, you’ll be much more likely to trade emotionally. Fear, greed, hope and anger can cause havoc and lead to disastrous trading decisions. But by planning your trades in advance you can stay composed, no matter what the market circumstances.
The starting point is deciding what style of trading suits you best. For instance, day traders never hold a position overnight. They are constantly watching the markets to spot short-term trading opportunities and may be in and out of a market multiple times in hours, or even minutes. They will be quite happy to risk £50 to make £50, operating on a low risk : reward ratio. Day trading is certainly exciting, but also time-consuming. So, it’s not for everyone. In contrast, trend traders may keep a position open for weeks or even months. They study charts to identify when a major trend in a market is developing, whether up or down. Then they look to trade in the direction of the trend until there’s an obvious change in direction. Swing traders are similar, although they are prepared to initiate trades that go against the underlying trend, hoping to profit when markets correct after a significant move. Both would hope to make maybe three to five times as much profit when compared to their risk. Meanwhile, position traders are really long-term investors. They tend to ‘buy and hold’ company shares, looking to build a portfolio and reinvest dividends. They don’t trade on margin, so they don’t employ leverage. Consequently, spread trading and CFDs are of little interest to a position trader, unless they’re looking to hedge an existing position.
Now let’s turn to money management. While of immense importance, this is a fairly simple consideration with the first action being to identify how much risk capital you have. Risk capital is most certainly not money for day-to-day spending, nor for the mortgage, or for your pension, or that put aside for emergencies or even for holidays. This is money that you can afford to lose. If it’s gone, it won’t affect your lifestyle or financial security. Once you’ve decided how much you are prepared to risk, it’s important to divide up this capital into smaller packages. After all, you don’t want to risk everything on just one or two trades. Some traders say you shouldn’t risk more than 5% of your risk capital on a single trade. A few say the percentage can be higher, but most would recommend that it’s lower, maybe 2% or even 1% per trade. Whatever you decide, it’s important to keep any losses small and manageable. In this way they won’t hurt you, emotionally or financially, even if you have a series of losing trades.
How you make the split will depend on the amount you have to trade as well as your own attitude to risk. The more risk capital you have, the more you can divide it up. This in turn will give you more trading opportunities. Overall the aim is to keep losses small and manageable, so you still have enough risk capital to continue trading. 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. It will also help with another key part of your trading plan - developing clear instructions for position sizing in relation to the size of your account. Once you’ve decided on how much you’re willing to risk on each trade, you have to apply this limit every time you discover a trading opportunity. We’ll illustrate this point with an example:
Let’s say that you have trading capital of £5,000 and you decide that the maximum you’re prepared to risk per trade is £100, or 2%. Now, perhaps you have been following the UK 100 market - it’s trading around 7,355 and trending upwards. You want to buy the index but not at current levels. You study your charts, apply some technical analysis (see below) and identify a decent buying level around 7,320 while a good selling opportunity comes in around 7,400. The latter may be an area of resistance, marked by the inability of the index to break above this price. You now have the potential for a trade. You decide to put on a limit to ‘buy’ at 7,320 and then sell to take a profit at 7,400 – potentially an 80-point gain. You have already decided that you will risk no more than £100 on the trade, so you could simply put an order to buy £10 per point with a stop 10 points below for a risk of £100. But this takes no account of how the UK 100 may swing around even if the overall upward trend remains in place. In fact, in this example the chart suggests that the UK 100 could fall back to 7,300 where there is a major support level, and the upward trend would remain in place. You decide to put a stop in at 7,295 – 25 points below opening level. To make sure your risk is around £100, this would mean opening a trade of £4 per point, at the most. You may decide to be more cautious and limit it to £2 per point, hopefully keeping the potential loss to £50 (assuming no slippage).
Now you have a limit to buy £2 per point to open - 7,320
You have a limit to sell £2 per point to take a profit – 7,400
And you have a stop to sell £2 per point at 7,295 should the UK 100 move against you
You have decided to trade £2 per point, so your risk is around £50 with a profit target of £160
This gives you a risk : reward ratio of around 1 : 3.
So, you have used risk and money management together with some technical analysis to plan a trade.
Bear in mind, that while in this example you’re risking £50 of your £5,000 risk capital (or 1%), you will need to deposit £732 (7,320 x £2 x 5%) as initial margin on the position. Consequently, there will be a limit on the number of trades you could have open at any one time even with a healthy £5,000 of risk capital in your account.
Good risk management involves using orders such as stops and limits to help you plan your trades. But how do you decide where to place these orders? This is important. After all, these are the levels that you’re choosing to open and close your positions which, in turn, will determine whether your trade is profitable or loss-making. You need to be able to identify significant price levels, and this is why it’s important to have some knowledge of charts, drawing tools and technical indicators. Charts will help you identify areas of support and resistance which will be invaluable in helping you decide where to enter and exit a trade. If these terms are all new to you, then it is worth putting in some