Risk management is a key component to successful trading. Without it, traders are dangerously vulnerable and could make just one or two bad trades before losing all their hard-earned money.
Remarkably trading risk management is an essential but often overlooked prerequisite to successful trading.
That’s because risk management helps negate losses by protecting traders from losing their money. If a trader can successfully manage risk however, they open themselves up to the potential of making significant money in the market.
Below we’ve listed seven easy risk management strategies that traders new and old can use to keep themselves trading as securely and safely as possible.
- Follow the one-percent rule
The one-percent rule is a risk management strategy capable of minimising losses when day trading stocks. This rule suggests trading no more than 1% of your capital or your account on any given instrument at a time. For example if you were to have $15,000 in your account – like our funded traders do – then this means not risking more than $150 per position.
The idea behind this guideline suggests that for every dollar invested in an individual stock there shouldn’t be a maximum risk worth over two dollars ($2), which is why it’s a common strategy amongst traders who have accounts under $100,000.
However, even traders who have accounts with much higher balances may choose to trade lower percentages (less than 1%) to mitigate risk because they know that as the size of their account increases, so too does the size of their position. One of the best ways to keep losses to a minimum therefore is to keep the rule under1% to prevent risking substantial amounts.
- Deploy stop-loss and profit points
Stop-loss points are a set price at which traders will sell their position and take on a fixed maximum loss. Traders often use these to prevent the “it’ll come back” mentality, as well as limit their potential for loss before it escalates any further than anticipated. For example, if a commodity breaks below key support levels, many traders will react by selling the particular asset instantly. This prevents too much damage from being done later down the line.
Alternatively, a take-profit point is the price at which a trader will sell out of their position for profits. It’s often reached after an asset has had a large move up (if Long) or down (if Short), and traders want to end on that note instead of waiting around in case it goes back to where they bought it.
Technical analysis is usually used to set stop-loss and take-profit points but fundamental analysis can play just as important a role in the timing. For example, if a trader is holding stocks ahead of a company’s earnings report and excitement is building around the company’s performance, they may want to sell their stocks before the news hits. They do this because expectations have become too high – regardless of whether or not their take-profit price has been met yet.
To set stop-loss and take-profit points more effectively, consider:
- Using longer-term moving averages for volatile assets. This reduces the chance of meaningless price swings triggering stop-loss orders to be executed.
- Adjusting the stop-loss or take-profit in accordance with the market’s volatility (e.g. using the Average True Range (ATR) indicator). If the asset price isn’t moving dramatically, the stop-loss and take-profit points can likely be tightened.
- Using known fundamental events like earnings releases to guide key time periods to exit or enter a trade. During these periods volatility can rise leading to redundant orders being executed.
- Consider your own risk tolerance
We all have a risk tolerance, and it’s entirely dependent on the following factors:
- Your age
- Your trading knowledge
- Your trading experience
- How much you can afford to lose
- Your investment goals
You may be a more conservative investor or a risk-taker, but it’s important to know what your tolerance is and keep that in mind when trading. It’s not just about sleeping better at night knowing you’re trading the right amount of money; it’s about keeping you in control of your trading and increasing your likelihood for success.
- Set a risk/reward ratio
Following a risk/reward ratio, also known as RRR, is a risk management technique that can definitely increase your chances of being profitable in the long-term by setting highly effective stop-loss and take-profits.
Risk/reward ratios compare and measure the distance between the entry point of your trade, and where you have set your stop-loss and take-profit orders.
It’s advised that day traders should aim for a minimum risk/reward ratio of 1:2 (i.e. take-profit level 2x the distance from entry price compared to the stop-loss), whilst longer-term swing and position traders can aim for a wider ratio of 1:3.
What that means in practice is if your entry-level and stop-loss order level was to be set at 20 pips, and the distance between the entry point of your trade and the take-profit point was 60 pips, your risk/reward ratio would be 1:3, because you would be risking 20 pips to make 60 pips (60/20 = 3).
The risk/reward ratio is a necessary tool involved in setting stop-loss and take-profit orders, and any trader should consider using it to effectively manage their risk.
Related Reading: What Are Pips and Other FX Trading Acronyms: The Glossary
- Stay in control of your risk per trade and keep it consistent
New traders are likely to make more mistakes when compared to traders with significant experience, which is where risk per trade management can help. Considering your risk per trade as a percentage of your capital, and setting it at a conservative level, can help to minimise risk by not leaving you vulnerable to large losses in a short time-frame..
A good starting point for a traders risk per trade would be to not risk more than 0.5-1% of their available capital per trade. This keeps the risk small by only risking a small proportion of their overall trading capital.
Applying our aforementioned risk/reward ratio to the 1% at a ratio of 1:3, a successful trade would also return 1.5-3%.
But learning your risk per trade is not enough: You must also keep your risk consistent. Many new traders will be ruled by emotion the moment they start making profits, and this is what eventually leads to huge losses in their capital because they are risking more than they can afford due to over-confidence.
Trading psychology helps traders to manage their emotions and remain objective, which protects them from losses. Learn more about the advantages of trading psychology here.
Keeping your risk consistent prevents you from becoming overconfident and risk-averse, and it’ll help you stick to your trading plan – the one thing that can guide you to success if used correctly.
- Diversify and hedge
The one golden rule of trading is to never put all your eggs in one basket. Diversification is the best way to maintain a portfolio that is sustainable and is protected from significant loss or risk.
You can diversify your instruments across the types of trades you make – for example, trading in commodities such as metals as well as equity indices.
Not only can diversifying across different markets help to manage your risk, it can also open your tradingup to more opportunities which can result in an overall profitable outcome.
In the world of Forex trading, all traders can use risk management techniques to improve their trades. Test your risk management rules before trading in live markets back-testing and then forward-testing on demo accounts while reviewing your trade history regularly for any lessons learned that you can apply moving forward.
At Alphachain we believe in growing the next generation of trading talent. That’s why we offer a range of funded programmes designed to turn rookie traders into professionals who start trading on live accounts worth up to $20,000. To find out what makes our trader development programme so successful, read more about our funded programmes here.