Risk management is defined as the practice of identifying, analysing and taking steps to minimise the downside of a transaction in advance.[1] Any entity involved in crafting decisions regarding the financial well-being of itself or others regularly utilises the tenets of risk management. A few examples of these entities are corporations, banking institutions, governments and individual retail traders.
In the realm of active trading, risk management is a discipline essential to sustaining profitability. If the issue of risk is not thoroughly addressed before entering the marketplace, unexpected volatilities can wreak havoc upon the trading account. It is imperative that risk is put into the proper context each and every time an order is placed at market.
Depending upon the type of trading and market being engaged, your approach to risk management may vary. However, there are four basic actions that can be extremely useful in limiting risk exposure:
- Adherence to a comprehensive trading plan
- Use of protective stops and profit targets
- Aligning risk to reward
- Prudently utilising leverage
No matter if you're trading futures, forex or stocks, the number-one reason a majority of traders are forced to leave the market is untimely capital loss. Through taking an aggressive stance toward risk management, the odds of blowing out the trading account fall dramatically.
Developing A Comprehensive Trading Plan
The contemporary marketplace is a fast-paced environment with seemingly infinite possibilities. If you're not adhering to a strategic framework while interacting within its bounds, the potential for catastrophe becomes very real.
A robust trading plan addresses several elements essential to conducting operations in a regimented manner. The following questions must be answered thoroughly while in the process of building a rules-based approach to the markets:
- Strategy: Is the adopted methodology rooted in technical or fundamental analysis? Is a swing, day, or intraday time frame most desirable? Is the strategy automated or discretionary?
- Ideal Market(s): Which products offer optimal levels of liquidity and volatility for the selected strategy?
- Money Management Parameters: Given the available capital resources, which safeguards are necessary to protect the account balance? What kind of trade management parameters are best suited for success?
Engaging the markets via a detailed trading plan limits many of the risks involved when you're simply "shooting from the hip." Individuals can build a statistically verifiable track record and trade consistently according to a structured approach. In turn, bad habits rooted in emotion, such as overtrading and reckless money management, may be reduced or eliminated.
Developing and following a suitable plan is the first step in eliminating many of the unnecessary risks associated with active trading. It must be easily understood and followed routinely in order to be effective. A comprehensive trading plan ensures the trader has the best possible chance of achieving replicable results.
Protective Stops And Profit Targets
Protective stops and profit targets are integral parts of almost any risk management approach. When used consistently and within the context of a comprehensive trading plan, stop losses and profit targets ensure that downside risk is limited while acceptable returns are locked in.
A protective stop or stop-loss is an order placed at market that runs contradictory to the direction of an open position. Protective stops are placed at a price level above active short positions (buy orders) and below open long positions (sell orders). Upon price reversing to the location of the stop loss, the open position is automatically liquidated or closed-out.
Stop-losses are one of the most valuable tools implemented by active traders to limit potential liabilities. They may be placed at market using any number of strategies. Protective stops are typically utilised in concert with an appropriate risk/reward ratio, technical indicator or predetermined monetary value.
Profit targets are applied to lock-in or guarantee that a gain is realised from a beneficial move in pricing. Profit targets are executed in a similar fashion as stop-losses. A limit, stop-limit or stop-market order is placed at market in opposition to the open position—sells for longs and buys for shorts.
Profit target and stop-loss order locations are largely subjective, but they're commonly defined by using various aspects of technical analysis including support and resistance levels. The primary difference between the two is that profit targets are placed ahead of price, not behind it. When the designated price point is hit, the resting order is triggered locking in a gain.
Profit targets and stop-losses play a key role in risk management. While the stop-loss limits a trade's ultimate downside, the profit target ensures that gains are realised and not given back in the wake of negative price action.
Balancing Risk And Reward, Understanding The Impact Of Leverage
The business of active traders is to frequently interact with a market, putting capital in harm's way to achieve financial gain. To accomplish this task consistently and avoid abnormal account drawdowns, risk must be properly aligned with reward.
A risk vs reward ratio is a tool used to quantify the potential return and risk exposure facing a specific trade. It may be defined in terms of currency, pips, or ticks. The setting of profit targets and stop losses are key elements in developing a risk vs reward ratio.
For example, the following long trade in the EUR/USD illustrates the relationship between stop-loss/profit target location and risk vs reward:
- Trader A decides to go long in the EUR/USD from 1.1800
- The stop-loss is placed below a relevant 50-period Simple Moving Average at 1.1775.
- Utilising a Fibonacci Expansion, Trader A expects strong bullish price action toward resistance and places the profit target at 1.1850.
- The risk vs reward for this trade is 25:50 or 1:2.
In the above example, the use of financial leverage is held constant. While it is true that the maximum loss on the trade is 25 pips, an optimal pip value must be found. This is easily accomplished by calculating a percentage of the account balance suitable to be risked on the trade.
Concrete guidelines for implementing leverage must be included in the trading plan. In the event that an abnormally large position is taken, undue risk is assumed and a loss may be devastating. The degree of leverage placed on a single trade is best quantified in terms of available capital. Adhering to a static percentage, such as 3% of the trading account balance, is a good way of ensuring that adequate risk controls are in place.
It is important to remember that increasing the position size or degree of leverage adds to a trade's risk exponentially. In simplest terms, the greater the leverage, the greater the risk.
Summary
By far, haphazard risk management practices are the number-one cause of new traders leaving the market prematurely. Through sticking to a comprehensive trading plan, using protective stops/profit targets, understanding leverage and the concept of risk vs reward, you can effectively limit the amount of risk exposure on a trade-by-trade basis.