Managing Trading Risk: An Introduction
Risk management is important and is the string that ties your different trading activities together.
There is a common saying in the trading community that “Good traders manage risk, bad traders chase profits.” Although it may sound like a cliché, successful traders know that it’s true. Risk management starts from the time a trade is being considered until it is closed out.
Risk Management – What is it and Why it is Important
Risk management is a crucial factor in achieving trading success. While it isn’t possible to achieve returns without risk, risk must be wisely managed. Typically, high risk is associated with high returns, but that is not always true.
High risk can mean that without proper capitalization, you could risk losing your trading equity. Risk management is important and is the string that ties your different trading activities together. Risk management is what brings flavor to your trading strategies or approaches.
Risk Management Concepts
There are various concepts of risk management. From the very broad margin and leverage to managing risk on the individual positions. Here are some key aspects of risk management to pay attention to.
Margin and Leverage
Margin and leverage determines the broad scope of risk management. It is in fact the starting point of risk management in your trading. Margin and leverage go hand in hand.
Briefly put, the leverage ratio is the amount of extra leverage you can use for every $1 invested. For example 1:100 leverage ratio means that you can control $100 for every $1 of trading capital invested.
This typically maximizes your controlling position in a trade but also increases your risks (and profits) by the same proportion. Margin, on the other hand, is the amount of money that is required to be locked in as collateral when you open a trading position. The margin amount is deducted from your trading capital and locked in during the entire period that your position remains open.
It is now obvious that the first step in risk management is to ascertain how much leverage you want to use and also to consider the margin requirements when opening a position. While using high leverage might seem tempting, it will also increase your risks by the same proportion.
A good starting point in deciding how much leverage to use is to know how much capital you are willing to risk. An ideal leverage ratio for the currency markets is 1:50 – 1:200 depending on your trading capital. You should also realize that the higher the leverage, lower the requirement margin is. Learn more about forex leverage and margin here.
Position Sizing & Trade Size
Position sizing is the concept which asks a fundamental question “How many contracts should I trade (or risk) on a trade.” The resulting answer shows you what trade size you should use in order to meet your risk tolerance requirement.
Most traders usually ignore position sizing. Some traders randomly pick a trading size (lot size), while some stick to the minimum lot size (which is generally 0.01 lots or micro lot). Trading with the minimum trade size can be good, but it also dwarfs your equity growth. On the same note, using a higher trade size means increased risks.
So how does a trader make use of position sizing? There is no single rule to answer this, but here are important guiding questions:
- How much of my equity can I risk on this trade Possible answers would be 0.50%, 1% etc… meaning if your equity is $10,000 then at 0.50% your risk would be $$50, or at 1% you would be risking $100.
- If I want to risk x% on a trade, what size position should I trade? Answer: You will need to determine your stop loss level. If your stop loss level was 10 pips from your entry, then at 1% risk or $100 you can trade at most 1 Standard Lot where 1 pip equals $10 (10 pips x $10 = $100). You can further break this down into multiple positions such as two 0.50 lots, or even lower. The required margin amount should be considered which helps you in opening the appropriate lot size.
- What returns to aim for? Answer: Now that you have decided to invest 1% on a trade, you would then have to look at the potential returns that could aim for. Typically a 1:2 risk-reward ratio is acceptable. Meaning that for every $1 that you risk, you expect to realize $2 in profits.
If the above calculations seem difficult or tedious, fret not. There are many automated trading calculators which can instantly give your position sizes by simply entering a few details such as your account leverage, the currency pair, the risk amount and so on.
Using Stop Losses and Their Importance
Stop loss orders are one of the essential risk management tools every investor needs to employ. A stop loss order should always be placed on a trade. When you place a stop loss order, you are in effect telling your broker to exit or close your position if your trade hits the specified stop loss level.
As an example, if you went long on EURUSD at 1.1008, and you set a stop loss for 10 pips, which would be 1.1018, then if EURUSD falls to 1.1018, your trade would be closed out for a loss of 18 pips (or its appropriate dollar value based on the contract size that you traded).
Trading without a stop loss is a perfect recipe for disaster as sudden spikes or Black Swan events can easily consume your entire trading equity.
As a general rule, every order that you place should also be accompanied by stop loss orders. Once a trade has moved a certain number of pips or points in your favor, reduce your risk by moving your stop loss price to the break-even level.
A break-even level is the price level at which you have entered the position. If the price reverses and hits your break-even stop loss level, you would be out with zero risk.
Hedging to Minimize Risk
An advanced strategy to manage risk is by hedging. First of all, this should not be attempted if you are new to trading. A certain level of expertise is required to be successful in using hedging as a way to mitigate risk. Hedge trading, as the name signifies is hedging your existing positions against potential losses. Hedging can be achieved in the following two ways:
Simple Hedging: This involves placing a buy and a sell order on the same currency. This ensures that you are stopped out at zero risk, regardless of which way prices move. However, simple hedging is a bit more advanced than it seems. Professional traders make use of simple hedging as way to recover existing losses.
Assume you are long on EURUSD at 1.10 and you expect the price to go higher. But what if EURUSD rises only to 1.1050 and then quickly reverses. If your stop loss was set at 1.09 (100 pip stop loss) and you use simple hedging, you could short EURUSD at 1.09.
While your long position would be closed out for a 100 pip loss by the stop loss order, your short position at 1.1050 would have earned you 150 pips in profit (1.1050-1.09). As you can see, the simple hedging method gave you a net gain of 50 pips (-100 on the long position and +150 on the short position), as compared to merely exiting with -100 pips in losses.
With simple hedging, traders should first check if their broker allows this. Not many retail forex brokers allow hedging on the same currency pair.
Advanced Hedging: In this version of hedging, traders take multiple positions on different instruments. This is achieved by what is known as ‘Currency or Asset Correlation’. The concept of correlation states that certain assets tend to behave similarly, known as positive correlation while some asset classes move in the opposite, known as negative correlation.
For example, in a risk-on mode, safe haven assets (gold, yen) fall, while risky assets (equities, commodity risk currencies) rally. The contrary is true in a risk-off mode. Using advanced hedging via asset correlation, traders can use it as a way to either double their investments by placing more orders in positively correlated assets in the same direction or use the correlated assets to place opposite orders when your existing positions are under the threat of being stopped out.
Risk Management – There are no Guarantees
In conclusion, traders should realize that the financial markets are risky and that there is no guarantee that past performance is indicative of future gains. Risk is an essential element of trading and traders should realize this fact.
However, using robust risk management techniques, traders are able to better control on how they can minimize their exposure to risks.