Managing risk is one of the most important concepts in trading. Many beginners in trading forget about capital management, and this can lead to large losses and a significant loss in confidence. A profit or loss depends on the diversification of the portfolio, the amount of capital invested in the security and the size of the account. There are many types of risks and here are few examples: Credit Risk, Interest Rate Risk, Volatility Risk, Settlement Risk, Market Risk, Liquidity Risk, Country Risk, Operational Risk, Model Risk, Currency Risk, Legal Risk, Systematic Risk and many other risks. Before one engages in investments, one has to understand each type risk one is exposed to before thinking about its management.
On every trading platform, there is an option to put a stop loss on your trade. A stop loss is initiated when the price of an asset reaches/touches that level. A stop loss is there to protect you from running huge losses. It is crucial that you keep one. Some traders keep a mental stop loss, but these traders have discipline and stick to their stop loss. The stop loss will sell the asset if a long position is taken. If a short position is held, the stop loss will buy the asset. In addition, there is a trailing stop loss
You’ve probably heard the saying, ’Run your profits, cut your losses’, stop losses and trailing stops can be used in an effective manner to run larger profits and cut losses. It is also advisable to cut losses early. It is advisable to set your stop losses according to the volatility of the market. A more volatile a market is the more slack your stop loss should be. This is primarily because any news events in the markets, will have a greater change in the market. But don’t set a stop loss to close to the market price, as a small movement can mean a loss.
Another method of risk management is diversification of risk as in a portfolio and hedgings. Having a spread of asset classes will help you to stop over thinking on one asset class. Having a diverse portfolio will help to offset any losses with gains in other assets. Over thinking on one asset classes can cause people to see things which the market is not displaying.
This leads us to the reward-to-risk ratio. The reward-to-risk ratio is commonly 2:1 but some traders like to use a 3:1 ratio. Using the 2:1 ratio for every trade you make, if your profit £2000 will be made and if a loss is recorded you will lose £1000. This is if the trade value is £1000. You should always ask the question to yourself “How much are you willing to lose?”
You should always have a plan, having plan will help you to develop discipline. This will then ensure that you stick to the plan. The plan should include a stop loss, take profit limits. In addition, the plan should take in to account political events and macroeconomic data.
For interested readers, we recommend further reading on the above listed risk types associated with the products that they are considering.