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Glossary
Risk Management
Definition
In order to control the size of your losses and protect your trading capital, you need to use risk management. Financial risk management is a plan and strategy you use to mitigate negative outcomes for your money and investments.
Why use a risk management strategy?
There is risk across all aspects of trading, with zero guarantees that prices will move the way you expect. That’s why you need a solid risk management plan that limits your exposure and allows your investments to ride the waves of the markets.
In its simplest form, risk management prevents traders from losing their entire investment in one bad trade. Trading is a battle of emotions. It can be hard to accept losses, as we’re not hardwired to do so. However, by holding on to positions too long hoping they’ll turn around, chances are you’re more likely to incur an even bigger loss than if you’d closed the position sooner.
Even the most experienced traders will incur losses in the markets. It’s how you manage those losses that enable your investment to live to fight another day, taking full advantage of the abundance of profitable opportunities in the markets.
Risk management is essentially sound money management. It could be determining an acceptable position size relative to your capital, hedging your investments in opposing markets or trading during hours you know are most profitable relative to your trading strategy.
In its simplest form, risk management prevents traders from losing their entire investment in one bad trade. Trading is a battle of emotions. It can be hard to accept losses, as we’re not hardwired to do so. However, by holding on to positions too long hoping they’ll turn around, chances are you’re more likely to incur an even bigger loss than if you’d closed the position sooner.
Even the most experienced traders will incur losses in the markets. It’s how you manage those losses that enable your investment to live to fight another day, taking full advantage of the abundance of profitable opportunities in the markets.
Risk management is essentially sound money management. It could be determining an acceptable position size relative to your capital, hedging your investments in opposing markets or trading during hours you know are most profitable relative to your trading strategy.
What makes a successful risk management strategy?
There are four key elements you should consider when designing and implementing a risk management plan:
- Set a limit for your trading capital: Consider a set amount that you wish to invest or trade. As part of a rock-solid risk management strategy, you should allocate a percentage of your total capital to each type of investment. Whether it’s equities and commodities to hold for the long term or forex pairs to day trade, you should define how much of your money you’re prepared to risk for both long-term and short-term investing and trading (without risking everything you own).
- Guard against the threat of slippage: Some stop-loss orders may have to be filled at a worse price than the price you wanted. That’s because if there’s any significant volatility in the market, it may not be possible to fill your entire order at the requested price. The difference between the stop price requested and the execution price is known as slippage. To avoid potential slippage, consider paying a premium for a guaranteed stop-loss order. This guarantees your trade will be closed at the exact price requested (and then you are charged a premium for this guaranteed price). If the order is never triggered, you are not charged the premium.
- Set a fixed risk-reward ratio: One of the safest things you can do when starting out as a financial trader is to define the risk-reward ratio you’re prepared to accept. For example, it is recommended for most beginners to opt for a 1:1 risk-reward ratio. This means you’ll risk one unit for one unit of potential profit. You’ll set a stop-loss order at a maximum loss of one unit and a take-profit order for one unit of profit. Using this ratio means that you only need to be correct with your trading entries 50% of the time to break even.
- Decide on the maximum number of positions you want open at one time: You may want to set a limit for the number of open positions you want simultaneously. Risk-averse traders will only use a certain percentage of their trading capital at one time. This is to help safeguard the rest of their investment capital in case of an unprecedented “Black Swan event” (major market crash) which puts open positions in jeopardy.
Also, consider the importance of diversification: don’t open too many positions within the same asset class. Hedging across multiple assets is key to avoiding opening positions on too many closely linked instruments.
Why is risk management important when trading leveraged products?
Risk management is particularly important for those who trade using leveraged products. If you’re trading CFDs or forex on leverage, this means you don’t need to deposit the full value of your open position into your trading account. If your broker allows you to trade on a 5% margin, you’ll only need to deposit 5% of the position. A leveraged position of 10:1 means that for every $1 you open, your potential profit or loss is 10x that amount.
Unsurprisingly, profits and losses can quickly accrue by trading this way, so there is high risk involved. To keep potential losses under control, a sound risk management plan is needed, including concrete stop-loss and take-profit order placement to prevent natural emotions like greed from influencing your trades.
What does risk management mean for traders and their portfolios?
Risk management is about supporting your trading strategies and hedging your personal biases. With a watertight risk management plan in place, you'll become more comfortable taking losses without getting stuck. You can move on to the next profitable opportunity, safe in the knowledge that you’ve only taken a small hit that can be wiped out by the next profitable trade.
Even the most successful traders with vast resources only risk tiny percentages of their capital on any one trade—something like 1%–2%. If you go with 1% risk per trade, you would have to experience 100 consecutive losing trades to lose all of your capital. That’s highly unlikely as long as you have a sound trading strategy and adhere to your risk management plan at all times.