AB13 - What Is Risk Management?

"Risk management is perhaps one of the essential topics that you should get familiarized with. To quote the famous Warren Buffet, the first rule of investing (or trading for that matter) is not to lose money. His second rule is to follow rule #1. As you can see, risk management is something that is applied across all levels of the financial markets. From short term speculating, or day trading to long term investing. The key to success in trading is to ensure that you do not lose money. But you might wonder how that is possible when losses are a common factor when trading? This comes by means of applying good risk management principles. In this article, we introduce you to the concepts of risk management and also outline some basic guidelines that you should know by heart. These rules should be fundamental to any trade that you take, regardless of the trading strategy."

Risk management in forex is one of the most important aspects that is directly related to the outcome of your success as a trader. Simply put, risk management is the ability to contain or limit your losses. This is done in a way that you do not end up losing all your capital on just one single trade.

Risk management is widely practiced in almost all fields of finance. From accounting to trading, you will find that risk management is used. This only goes to show the importance of risk management when it comes to trading or managing your money in the forex markets.

Risk management will not show you how to make profits, but on the contrary, it shows you how not to lose too much money. Of course, risk management by itself is no means of preventing you from taking losses.

Losses are an integral part of trading. Risk management allows you to trade in such a way and manage risk so that your entire trading account is not at risk. This means that despite taking a loss, you will still be able to trade.

Of course, if you are consistently losing, then there is nothing that risk management can do. You will have to go back to the basics.

To illustrate this factor, let’s take a first example where a trader has $10,000 in trading capital. This trader risks 25% of his capital on each of his trades. In other words, they risk $2,500 per trade. Assuming that they have a risk/reward set up of 1:2, which means that for every $2,500 that they risk, they make $5,000.

If this trader has just four consecutive losses, their entire trading account is blown up.

Now compare this to another trader who risks only 1%, for the same trading capital of $10,000. To lose this entire trading capital, the trader will have to make 100 losing trades. Now if this trader simply follows the rule of 1:2 risk and reward set up you can see that they are able to trade longer.

You might wonder what is the usefulness of being able to trade longer. Well, the longer you are able to trade without risking all your trading capital, the greater is the chance that you will be able to recuperate your losses.

What are the principles of risk management?

There are certain guidelines that traders can use in order to practice good risk management. Some of them are outlined below.

  1. Always trade with stop loss and/or trailing stops: This is done so that you are limiting the risk on the trade right away. Once your trade moves against you and reaches a certain threshold, the stop loss will protect you from taking on further losses. Trailing stops are used to move the stop losses every time price moves a certain pips in your favor. With trailing stops, you are locking in profits as and when the markets give you the opportunity.
  2. Do not risk more than 1% of your capital on a trade: This is the most widely quoted principle of risk management. You should risk no more than 1% on any trade at any given point in time. This ensures that you are able to sustain or absorb the losses, but at the same time, it allows you to get back into the game.
  3. Understand how leverage and margin works: In the previous articles in this section, we explained the concepts of leverage and margin. It is essential that you have a good understanding of how leverage and margin work. They are closely tied into how you will be able to trade. Being overly leveraged or trading with large lots can easily lead you into a margin call which should be avoided.
  4. Manage risk, do not chase profits: It is easy to get tempted by the markets and traders often focus on how much money they can make rather than adjusting or managing their risks. When you manage risk, the profits will automatically follow. As long as you do not end up losing more, a consistent model will automatically see the profits coming in.
  5. Move to break even whenever possible: Many traders prefer the set and forget method of trading. Here, the trader enters a trade via limit orders and sets the take profit and stop loss level. Once the trade is set up, it is either in profit or closed with a loss. Leaving risk on the table when the market is moving in your direction is a folly. Avoid this at all costs.
Read 884 times Last modified on Saturday, 15 June 2019 11:58