Trading risk management is a strategy or system assessing the potential risks of investing or allocating funds in a business or service and determining necessary steps to maintain an ideal balance between income and expenditures.
In financial trading, risk management is an undeniable process for examining the level of risks against the potential rewards. According to market experts, individuals trading without a proper risk management strategy are less likely to survive in the long run.
This guide explains risk management in trading and how it affects your profits and losses. Also, we’ve discussed some top risk management options for forex and stock. If you are a beginner in trading and risk management, this guide may change your idea of calculating profit and loss in trading forever.
Risk management in trading refers to the strategy of identifying the budgeted loss against the targeted profit. It helps you determine how much risk you can take for any particular trade based on your total investments and profit potentialities.
If you have already undertaken some trading courses or read through trading journals, you must have come across a trading myth – more than 90% of traders blow their first trading account. This myth has become a fact as most newbie traders lose their whole account balance within the first three months. And the worst scenario is that many of them keep repeating the same mistakes repeatedly until they lose their faith in trading.
Lower risks with realistic profit expectations
Beginners without proper knowledge of risk management are used to considering the abnormal amounts of losses targeting abnormal amounts of profits within short periods. But the result of such a reckless attempt to make quick profits ends up with a considerable amount of loss or an empty account. For example, you risk $200 for each trade in a $1000 account means you can afford to lose only five trades before blowing your account.
For instance, you have a $1000 balance in your trading account, and you’re willing to take a 2% risk of your total investment for each trade. It means your loss budget for each trade is $20. So, while trading, you must adjust your trading lot so that your stop-loss amount doesn’t exceed $20.
So, what was the benefit of maintaining a 2% risk budget for each trade?
Even if you are in an adverse trading position, a 2% risk for each trade means you’ll lose all the money only if you lose 50 trades in a row. So, even if you concede several consecutive losses, you’ll still have enough opportunities to fix your mistakes and rein the losing trend.
Trading is a marathon, not a sprint
Maintaining a proper risk to reward ratio is integral to risk management. It is essential to determine the percentage of budgeted loss against the potential gain. For instance, a 1:2 risk to reward ratio means your profit target is twice your loss budget. In this way, you’ll remain overall profitable if you win at least 40% of your trades.
Let’s have a look at how this strategy works.
Suppose you have a $10,000 account and your risk budget is 1% of your total capital, which is $100 per trade. So, according to the 1:2 risk to reward strategy, your profit target should be $200 for each trade. If you win 4 times out of 10, your total gain is $800 (4 x $200) against a $600 (6 x $100) loss. As a result, you are still in a $200 overall profit.
Risk management in forex trading is crucial, especially if you are a frequent trader. The forex market comprises thousands of tradable assets, offering numerous trading opportunities. So, it is important to adjust your risk limits based on the overall winning percentage of your trading strategy.
If you generally maintain a 60% winning rate, a 1:1 risk to reward can still keep you profitable. However, market experts suggest sticking with at least a 1:2 ratio to remain steady in the long run.
Targeting smaller gains against more significant risks is common in forex trading. It mostly happens when traders fall for short-term profits and forget the minimum risk management standard. Applying a lower risk-reward ratio may increase the probability of hitting your target. At the same time, using wider stop-loss limits puts you at the risk of making significant losses.
Forex traders are often advised to activate one trade at a time. However, depending on market conditions, sometimes you may trigger multiple entries simultaneously. It is important to follow a fixed daily loss budget in such a case, no matter how many trades you execute in a day.
If you allocate a $200 risk for each day and open two trading positions at a time, your stop-loss limit for each trade should be $100. If you think the $100 stop-loss is too narrow for a particular entry, you should stick to one entry instead of two.
For newbie forex traders, considering a daily 1% to 1.5% risk of the total capital is ideal. If you are well experienced and consistently profitable, you can stretch the daily risk budget to 2%. Considering such minimum loss begets every day helps you gain better control of your trading activities. It prevents you from overtrading and being tempted to weak signals.
Like forex, stock trading involves buying stocks when the price is low and selling them when the price is high. However, due to rapid changes in market conditions and uncertain volatilities, buying and selling stocks may not turn as simple as it seems to be.
Risk management in stock trading implements strategies for identifying the risk limits, profit targets, daily loss budgets, and trading volumes. Trading with such parameters protects our investments from market fluctuations or unfavorable trading conditions.
Depending on trading styles and expectations, the risk management strategy in stock trading can vary. Trading one stock at a time and sticking with the 1% risk per day rule can be ideal for beginners. On the other hand, experienced traders consider holding multiple stocks simultaneously to diversify the risks.
For instance, you may invest in non-cyclical industries and blue-chip shares for long-term investment. Stock prices of such companies get less affected during market fluctuations. At the same time, you may look over the penny stocks, which are highly volatile but offers short-term gains.
- Only consider an entry that can fill your risk to reward target.
- Placing a stop-loss limit is a must.
- Consider setting a profit target unless you love to let your trade run, targeting a higher risk/reward ratio.
- Diversify the risks by holding different asset classes in the portfolio
- Don’t exceed the daily risk budget.
Risk management table:
In many cases, traders begin investing within a standard risk management strategy but fail to continue with the process because of weak trading psychology. It mostly happens when a trader is in a winning or losing trend.
After winning a couple of trades, one might double the trading lot as the confidence mounts. But increasing the trading volume in an undisciplined manner puts you at the risk of extensive losses. At the same time, such attempts make you forget the basic principle of risk management.
In the same way, after conceding several losing trades, you might plan to evaporate the losses as soon as possible. But straining to cover a large amount of loss with a couple of high-volume trades is an unreal strategy that mostly brings unfavorable results in the long term.
So, you must stick to your risk management rule in every trading condition. If you continue getting adverse trading results, there must be an issue with your trading strategy. We may switch or customize our trading strategy to enhance the winning rate, but the risk management principle should remain intact.
Managing risk is a part of our daily life. While paying bills, rents, or purchasing household products, we intend to cut the cost to maintain a healthy balance between income and expenditure. Risk management in trading is the key to becoming a successful trader. It ensures the best utilization of the trading leverages by diversifying the investment. Trading within a profitable trading strategy and sticking to the risk management rules can transform you into a consistently profitable trader.