A Beginner’s Guide to Risk Management
Risk management is designed to reduce the size of your trading losses. Risk management techniques in your trading plan are essential to overall profitability.
Risk management is one of the most important skills to develop if you want to grow your trading bank. Even gifted financial traders come unstuck without mastering the basics of risk management.
This article at a glance:
- Risk management strategies and techniques help you mitigate your losses, especially when trading with a margin.
- Stop loss, take profit and position sizing are some common risk management tools.
- Calculating the expected return from a prospective trade helps to identify profitable trading angles.
- Two popular strategies to mitigate risk with open positions are diversification and hedging.
- Your risk to reward ratio can be helpful to maintain profitability in the long run.
What is risk management in trading?
Risk management in trading is designed to reduce the size of your trading losses. It preserves your trading account, and the rest of your bank lives to fight another day. Risk management limits the scale of your potential losses, and helps to remove the emotion from trading.
Traders can be tempted to hold on to losing positions for longer than they should, in the hope of returning into profitable territory. It's easy to forget that a losing position is as likely to become a bigger loss, as it is to break even or turn to profit.
Risk management often ranks low on the list of priorities among beginner traders. But without these strategies and an acceptable risk and reward ratio, profitable trading is impossible in the long run.
Why is risk management important in trading?
Financial day traders will often use leverage when opening positions in the markets. Leverage allows traders to maximize open positions in the form of a multiplier loan, for example 5x. This means you can get five times the level of exposure to your chosen asset, despite investing only one unit.
Although this might sound exciting, it does come with plenty of risks — potential profits are magnified 5x, but so are potential losses.
Even the most seasoned financial day traders will agree that there can be periods where the following occurs:
- You suffer a succession of losing trades
- You suffer occasional big losses where the price flies through your stop loss level
- Trading strategies that were previously profitable suddenly stop yielding a return
Unless you adopt sufficient risk management, the above periods can result in:
- Losing your entire trading capital
- Bearing losses that equate to a large chunk of your trading bank
- Being forced to close positions due to a lack of liquid funds to cover margins
When your hard-earned money is on the line, emotions can blur the lines and cause you to stop thinking clearly in the markets. This takes you one step closer to a bad decision that could land you in some serious financial trouble.
How to manage your risk?
The first step to risk management in trading is to plan your trades before executing them. There is a common saying in trading that you should “plan the trade and trade the plan”. Without a plan, you are all at sea with your emotions, with no exit strategy to prevent losses from getting out of control.
To supplement this plan, we’ll explore several risk management techniques as part of your trading education.
Risk management tools
Two of the most common risk management tools are the use of stop loss and take profit orders.
- Stop loss: A stop loss order is a command that requires a broker to close an open position at a predefined loss. This is particularly beneficial for trades that do not pan out the way you thought they would. A stop loss order is designed to cap potential losses.
- Take profit: A take profit order defines a price at which an open position should be closed for a profit. This works well for traders that are eager to earn more profits than they planned for. They tend to leave their positions open, to try and extract the most profit from the trade. This, in turn, can result in profitable positions retracting, ending in a loss.
- Position sizing: Position sizing relates to the number of units a trader decides to invest in a particular asset or instrument. Your trading capital and risk tolerance should both be factored in when setting an appropriate position size.
As a rule of thumb, most profitable traders will choose not to risk more than 1-2% of their capital on a single trade. Stop loss and take profit orders can then be used to set the position size and define the intended exit price (both for losses and profits).
Stop loss, take profit and position sizing are crucial tools to preserve trading capital and encourage long-term profitability.
Risk management calculator
Calculating the expected return from a prospective trade — even a commodity or a futures contract — helps traders to pinpoint the most profitable trading angles. Expected return is usually calculated using possible returns from different scenarios and the probability of them occurring.
Expected return = (Possible return for scenario 1 x Probability) + (Possible return for scenario 1 x Probability) + …
The probability of a possible return (either a gain or loss) can be determined using historical technical analysis. At the same time, more experienced traders are likely to use their assessment of the market to set their own probabilities.
Risk management strategies
Two of the most popular risk management strategies to mitigate risk with open positions are diversification and hedging.
- Diversification: Many traders look to diversify the types of trades they open. It’s a good idea to spread your trades across multiple instruments. Traders also spread their portfolio across multiple industries, look at equities with small and large market capitalizations, and consider trades in multiple geographic areas. The idea behind diversification is profitability from a range of sectors and asset classes will offset losing trades.
- Hedging: Some traders will also look to hedge an open position. A hedge requires a trader to take a position on another security that works in the opposite direction to the asset they are currently trading. Although hedging can reduce the potential risk, it also limits potential gains. CFD trading is often used as hedging instruments because they’re easy to short.
What is a risk to reward ratio?
A risk and reward ratio sets the size of the potential profit, relative to the size of the potential risk. To understand your risk-reward ratio, keep in mind the mechanics of risk and reward in financial trading.
Your risk, or potential loss from any open position in the markets, is typically limited by a stop loss order. Your reward is your profit target for an open position, i.e., the point at which you exit from a trade having made money.
To calculate a risk and reward ratio, you can simply divide your total profit target by the maximum loss value. For example, if you wish to win a 10-tick profit and your stop loss is set at a five-tick loss, your risk-reward ratio is 2 (or 1:2). This means that for the extent of the risk you are willing to bear, you expect 2x in rewards.
A general rule of thumb about risk and reward ratios is that the risk should never be greater than the potential reward. If the risk is greater than the reward and you decide to trade using leverage, the potential losses will be magnified further still. In fact, a strategy like this could tear through your bank balance.
Beginners should look to a risk-reward ratio of 1:3 or even 1:4 to preserve trading banks. As newcomers to the markets, this is especially so as their losing trades may outweigh the profitable ones.
As you gain experience, you may wish to increase that to 1:2 or even 1:1. A 1:1 risk to reward ratio is workable for traders that have seen success with their trading strategies at least over the medium term. In this case, traders only need to be right with their entries 50% of the time to break even. Anything over a 50% strike rate on trades equates to profit.
Margin risk management
By trading on margin, you can get access to positions multiple times the size of your initial deposit. If you plan to embark on margin trading using leverage, remember to adopt sufficient risk management techniques to deal with magnified profits or losses.
This means your stop loss order must be that much tighter based on your risk to reward ratio.
For instance, if you have deposited USD 100 for a trade with a 1:1 risk and reward ratio, your maximum loss should still be USD 100. If your broker provides you with 20x leverage, you now have an exposure of USD 2000 in the market. In this case, your stop loss order will need to be 20 times tighter to safeguard against escalating losses.
Risk management FAQs
What is modern portfolio theory?
The concept of modern portfolio theory was devised by Harry Markowitz in the 1950s. Markowitz’s hypothesis is based on an investor seeking a maximized expected return for a specific level of risk. The risk is measured using the standard deviation of a portfolio’s likely rate of return. This is helpful to define an optimal risk portfolio, i.e., the ‘sweet spot’ of optimal risk for optimal, instead of more risk for a proportionately lower return.
What is the 1% Rule in trading?
Day traders in the financial markets often abide by the “1% Rule”. The theory behind this is that you should never commit more than 1% of your trading bank towards a single trade. Not even the world’s best financial traders make a profit with every trade they make. By adopting the 1% rule, it would take 100 consecutive losing trades to have your entire trading bank wiped out. Even if your maximum loss is set at 1%, this doesn’t limit the amount of profit you can make per trade. It just guarantees your worst-case scenario from the moment you enter the market.
Can you implement stop loss and take profit orders in MetaTrader?
MetaTrader 4 and MetaTrader 5 are both supported platforms at INFINOX and IX Prime. These trading platforms offer a multitude of features to automate the execution of your trades, including stop loss and take profit orders.
Why can slippage effect stop loss orders?
It is possible for stop loss orders to be executed at a worse price than the one you originally set. That’s because of an issue known as slippage. This is the difference between the price executed and the target stop level.
Slippage or gaps occur between the price at which you want to close your position and the actual price for various reasons. Key news events can cause significant price volatility and price gaps in the market, while prices can open significantly higher or lower the following day.
There is also the danger of there not being enough volume for your stop loss order to be fully filled at your target price. Some brokers will offer guaranteed stop loss orders which ensure you get the exit price you set for a premium.
This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. INFINOX is not authorized to provide investment advice. No opinion given in the material constitutes a recommendation by INFINOX or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.