Ways to Manage your Risk
Always be Aware of the Downside
Before you place every trade you should calculate exactly how much you stand to lose in the worst case scenario. Remember that sometimes the market can move quickly or gap, meaning you might not be able to get out of your trade at the level you wanted to.
You need to keep the worst case scenario in mind, because if there’s a major market event, you may be overly exposed. This is particularly important to remember when placing leveraged trades, where your losses could be greater than your deposit.
Guarantee stop losses are available on certain platforms that i would recommend using if you are leveraging, look on the terms and conditions of your broker to do more research on the stop losses you are entitled to use.
Avoid Emotional Trading
When making trading decisions, you should distinguish between those which are rational and those which are emotional. Relying on ‘gut’Â feeling will almost certainly end in disaster, so it’s vital to back up your decisions with clear analysis. As we’ve seen earlier, creating a structured trading plan can help you manage emotional risk by providing clear guidelines and helping you maintain your discipline.
Diversify
If you often have more than one position open at any one time, you can help minimise risk by putting your money into a broad range of different investments – in other words, not putting all your eggs in one basket.
For example, if you put all your investment capital into the shares of a single company, you risk losing it all if that company goes bust. On the other hand, if you buy shares in many different companies, your loss from the one that fails won’t have such a devastating effect on your overall investment.
Similarly if you are long on a lot of stocks you may want to balance your portfolio and go short on a few. There are many ways you can hedge and cover your positions limiting your risk. It is always important not to be over leveraged in one direction and diverse your funds.
The best way to diversify is to spread your investment across asset classes. For example, you may end up having a portfolio made up of shares, commodities, property, bonds and other investments. These markets often move independently of each other, providing protection against one particular asset class underperforming.
Select Riskier Investments Carefully
If you do end up having a portfolio of different investments, it’s sensible to balance out any particularly risky trades with more stable assets. The investment risk pyramid is a handy model to help you decide how to spread your risk across various financial instruments.
Most traders will probably want to keep the bulk of their investments in safe assets that provide regular, if unspectacular, returns such as government bonds and other long term investments.
In the middle there are medium-risk assets, which should provide a stable return and also have the potential to appreciate.
At the top are the higher-risk investments which have the potential for huge returns but large losses too. The money you put into these high-risk assets should only be money that you can afford to lose without serious financial repercussions. Normally CFD leveraged trading for example would more likely be in that category. Short term trading, high risk trading.
Of course this is just a guide rather than a set of rules, so you’ll need to think carefully about the amount of time and money you have to invest, and the level of return you want to achieve when choosing which assets to trade.
Calculate your Maximum Risk Per Trade
Choosing how much to risk per trade is all about your personal circumstances. You’ll find some guidance that says don’t risk more than 1% of your trading capital per trade, while others say it’s ok to go up to 10%.
For me i think it all depends on your strategy and how proven it is to be profitable and consistent. If you have a trade that is known to be 90% successful then you may want to use more leverage on your trading account. However i would recommend to sticking to 1/2% of your account size, building up a track record is the most important thing and then the money will come. If you over leverage and try and make money to quickly the markets will normally come back to bite you.
Work out the Risk vs Reward Ratio of Every Trade
It is possible to lose more times than you win, yet be consistently profitable. It’s all down to risk vs reward.
To find the ratio on a particular trade, simply compare the amount of money you’re risking to the potential gain. So if your maximum potential loss on a trade is $200 and the maximum potential gain is $600, then the risk vs reward ratio is 1:3.
If, for example, you placed ten trades with this ratio and you were successful on just three of those trades, your profit and loss figures might look like this:
Over ten trades you could have made $400, despite only being right 30% of the time. That’s why many traders like to stick to a risk/reward ratio of 1:3 or better.
A word of warning though – if you’re taking on less risk for a greater potential reward, it’s likely the market will have to move further in your favour to reach your maximum profit, than it will to hit your maximum loss.
So, in the above example, the market would probably have to move three times as far in your favour to reach a $600 profit, than it would have to move against you to cause a $200 loss