Managing Risk: Establishing Trading Parameters
While this article will deal with some of the less “glamorous” aspects of trading in the spread betting markets, it can actually be argued that some of the points made here will be the most important elements that will determine your ability to achieve long term profitability in this business. Specifically, we will look at various methods and ways experienced traders manage their risk, which, in essence means the amount of capital that could feasibly be lost at any given time.
Focusing on Risk, Rather than Profit
With respect to managing risk, the first point that traders should understand is that experienced traders focus on the potential risk involved in any trade, rather than (or, at least, before) the potential profits for that same position are considered.
While this might seem counter intuitive, it must be remembered that there is no such thing as a “sure trade,” and any time someone tells you they have a trade that “can’t possibly fail,” that person is either delusional or is lying to you. Because of this, the first thing a trader must do (before any positions are placed) is to understand the amount of capital is being risked and to limit that amount to a number within an acceptable tolerance level.
A major factor when understanding you total risk level is to determine an appropriate position size for each trade. This refers to the amount you will be spending on each trade, in order to command the value of the underlying assets. For traders with smaller account sizes, smaller position sizes must also be used.
To get a sense how what an appropriate trading size will mean for your account, a good general rule to follow could be seen when traders limit their potential losses (at any one time) to a maximum of 2-3% of the total account size. Thus, if you have $10,000 in your account, you should never be risking more than $2-300 in the combination of your open trades.
Properly Using Leverage
Once we understand position sizing, the next question to ask is whether or not you plan to use leverage in your trades. Leverage (maximizing position sizes through broker credit) allows traders to substantially increase gains when positions are successful. There are, however, no “free lunches” in the trading markets and because of this, potential losses are equally maximized.
So, more conservative traders will likely want to avoid the use or leverage altogether, or at least use in in small amounts. If you are a more aggressive trader, you might want to take on the extra risk and increase your position sizes with leverage. But, either way, most experienced traders will tell you that as a general rule, leverage levels should never exceed 10:1. That is, $10 in position size (assets traded) for every $1 used as a deposit. Anything exceeding these levels is generally thought to be overly risky and unsuitable for serious trading.
Understanding Risk to Reward Ratios
The next concept that must be understood is the idea of risk to reward ratios, which is a critical element of risk management. Essential Risk to Reward refers to the amount of money you are risking, relative to the amount of money you stand to gain in a position.
For example, if I buy a stock valued at $5, and I expect its value to increase to $8, I stand to make $3 in the position. To take this trade, let’s assume I place a stop loss at $4, giving me a potential loss of $1. This would give me a risk to reward ratio of 3:1 (and the reverse would be true for selling positions. Most traders look for a risk to reward ratio of at least 2:1 before entering into any position.
Trailing Stop Losses
Last, a more advanced feature of risk management in the spread betting markets can be seen with trailing stop losses, which allow us to manage trades as gains are made. Criteria for trailing stop losses can be set before positions are placed, and should match your overall trading plan and risk tolerance level.
While it might seem that most of a trader’s focus should be on the potential gains that can be made at any time, this is rarely the approach that is taken by experienced traders. Since any trade carries with it the risk of failure, traders must have an acute understand of the amount of money that might be lost if markets move in an unfavorable direction. The elements discussed in this article help to outline the ways traders can properly manage trading risks when spread betting.