In the financial sector, pretty much everything has an element of risk. Your own bank account, despite you thinking it is the safest place for your money, there are risks holding it there. What happens if the bank collapses and cannot pay out your money?
There are always risks associated to investing your money and understanding those risk is imperative when it comes to trading assets.
Every time you take a trade you are risking your capital and that is the biggest risk of trading any assets. As a trader you therefore have a responsibility to manage your risk, maintaining that any losses are controlled and managed.
Essentially the most important thing is to keep your losses consistent. If you can choose the amount you are going to loser before you lose it, then you should stick to that much every time.
Risk Reward Ratio
Before we look at risk management strategies, we must first understand what a risk reward ratio (RRR) is. This is the ratio that measures how much you could potentially profit for every dollar you have at risk.
If you were risking £100 to make £100, your RRR would be 1:1. If you were risking £100 to make £300, your RRR would be 1:3.
It is normally advisable to never go below a RRR of 1:1 however this depends on your win rate. If you are hitting 50% win rate, then 1:1 isn’t enough to make profit. However, if your RRR was 1:2 and your win rate was 50%, then you would be making profit. Let’s do the math’s quickly
If you’re risking £100 in order to make £200 and you take the exact same trade 100 times.
50 wins & 50 Losses
(50 x £-100) = £-5,000
(50 x £200) = £10,000
= £5,000 Profit
This one example shows how important it is to stick to your strategy and making sure your psychology is correct to make sure you are not cutting your profits short or playing with your stop loss.
If you can get a RRR that works with your strategy and you stick to it then you can see the profits to be made.
In an ideal world then every time you took a trade you would simply take the trade and leave it. Let it either hit the target or stop loss. This is where psychology comes in, people get greedy and people get scared. This is why we would urge new traders to follow a strategy on demo before going live. If you can see it working on demo then it makes it psychologically easier to do when you’re on a live account
Risk Management Strategies
Stop Loss & Profit Orders – These are automatic orders that near enough every broker now offers. They are orders that traders can put into the market that once the price gets to that level they will automatically buy or sell the market at that price. If you use these orders every time, you can manage exactly how much you are going to lose every time.
While that sentence does not sound nice, it is very important that you get it into your head that you will lose and actually managing your losses is the foundation of making consistent profits.
Position Sizing – This is how much you put on each position. Depending on your strategy this may or may not be the same for each trade. Normally this will change for every trade you take, the reason being is because your stop loss will not always be the same distance from your entry.
Before you take a trade you should know exactly:
How many pips you are will to risk
How much money you are willing to lose (this should be consistent for every trade)
Trade Size (% of Account at Risk) – The amount you are willing to risk is up to the trader in question. However, you should think about it as a percentage and not as a numerical value.
It is widely recommended in the industry that you should not risk more than 1% of your account on any one trade. If you have an account of £10,000, then no trade should ever lose more than £100. This way it will take 100 bad trades in a row for you to blow your account. The chances of that happening are very slim.