Risk Management in Trading
Dec 27th, 2017
We thank Alexander Nixon for writing this post on Risk Management in Trading
Risk Management in Trading
Risk management is a necessary but often overlooked requirement to successful trading. The usual scenario is that traders prioritize finding accurate entry signals before learning the basics of risk management. However, this leads to financial failure. Investopedia reports that an estimated failure rate of 90% happens when trading.
Business insider documented that 4 out of 5 day traders around the world lose money. Only 1 in 100 do it well enough to be profitable.
It is impossible to experience profitable trading without having a good working knowledge on risk management. A trader needs to understand how to size positions, and create a positive outlook in trading. Setting orders correctly is also needed in order to become a profitable trader.
There are many factors that contribute to the reasons why traders treat risk management as low priority. However, the problem usually stems from the attraction of high profits. Nadex states that fear and greed are the controlling factors for traders. This is the reason why a profit of $1,000 in one week can sometimes turn into $10 in an instant. The desire to earn more without risk management is something many traders fall victim to. It is only through experience that they realize how important it is to minimize losses with proper strategy.
Risk management in trading isn’t very hard to do. You only need to apply the below steps when approaching trades.
Setting orders and the reward to risk ratio
The risk to reward ratio is the amount of money that you plan to risk against the amount of cash that you think you can gain. For example, if you believe that a trade may result in a $500 profit and $100 loss, the trade would have a risk to reward ratio of 5:1. This is a favorable setup. If you risk $100 in order to make $100, the ratio is 1:1. This gives you the same unfavorable return that you will find when gambling in a casino.
You need to set where you want to put your stop and profit order when you see an entry signal. This is very important and should be done before every trade. Measure the risk to reward ratio after setting up the price levels for your orders. Skip the trade if it doesn’t meet the requirements based on your trading budget. Never adjust your take profit or minimize your stop loss in order to achieve a better risk to reward ratio.
Many fledgling traders adjust their stop and profit orders in order to achieve a certain ratio. This is a rookie mistake that should be avoided at all times.
Set stop-loss points
Setting up stop-loss points can be effectively done using both fundamental and technical analysis.
Moving averages are easy to calculate and track. Key moving averages include the 5-, 9-, 20-, 50-, 100- and 200-day averages. They can be set up by applying them to a stock’s chart and see whether the price will react to them as either support or resistance.
An alternative to place stop-loss points is on the support or resistance trendlines. These can be mapped out by connecting previous lows or highs that happened on above-average volumes. The idea is to know at which levels do prices react to the trendlines.
Never use daily performance targets
Setting up a daily or weekly performance target is wrong. Traders must not think in terms of daily and weekly returns because it sets up a lot of pressure. It also creates the feeling of the need to trade.
Here are some ideas to set trading goals properly.
Short-term trading (daily or weekly): Concentrate on the best possible trade execution and how well you follow your reward to risk ratio.
Mid-term (monthly): Plan your trades in advance and follow your rules to the dot. Record your trades and make sure that you learn your lesson with every loss.
Long-term (biannually or annually): review your trades and concentrate how you can do your work better. This will let you gauge how far you’ve succeeded as a trader. Find weaknesses in your trading and adjust accordingly.