As the saying goes ‘trading is risky’, and it’s true, each trade carries the possibility of a loss or a gain. The question every trader should be asking is not ‘is trading risky?’, but instead, how to minimise the risk in order to maximise profits.
The key to smart trading is effectively managing your risk in order to make better trading decisions. The best place to start is with a risk management plan.
Let’s explore three key risk management techniques traders can use when managing their investment risk and building an effective trading strategy.
Technique 1: Educate yourself
The first step any trader should take when developing their risk mitigation strategies is self-education.
Start by learning the basics. In order to begin trading effectively, you need to be aware of what you’re trading. Do you want to own an asset, or a stock? If yes, then you should consider traditional trading. But, if you only want to make a profit on an asset, then CFDs (contracts for difference) may be for you. Do your research and find the best trading style to meet your needs.
Now you’re ready to discover the markets. Do your research. Interested in cryptocurrencies? Then do your best to learn all you can about the market, from ICOs (initial coin offerings), to white papers, or the latest value of bitcoin. This is all important info for deciding what to trade, and when.
Maybe cryptos aren’t your thing. The same applies to every other market. Whether it’s fiat currencies, commodities, indices, or stocks, keep ahead with the latest market news, earnings reports, political news, and charts. They will all help you become an informed trader.
Finally, get to know trading biases, and more importantly how to avoid them. Biases are unfortunately little tendencies in human behaviour that can impact the success of a trade.
Take the hot hand bias for example. If a trader believes him or herself to be on a ‘winning streak’ they are more likely to be careless with their trade. This can be either through placing a poor trade or increasing the volume of their trade unnecessarily. They believe they will win the next one, and this puts them at a higher risk of losing, as they haven’t traded based on facts or logic.
By learning about biases and being aware of them, a trader lowers his or her risk of making an unprofitable trading decision.
Technique 2: Stop-losses and take-profits
Now, you’re ready to hit the markets? Well, not quite. Before you start trading, there are two very important things you need to know – stop-losses and take-profits, the second of our risk management techniques.
Stop-losses and take-profits are two types of orders, or commands, you can give to your broker when managing your positions. They help protect against unnecessary losses.
A stop-loss is an order that is issued to ‘stop’ your trade when it reaches a predefined level in the event that the market moves against you, this ends your trade at the level you set to stop you incurring further losses.
For example, if you’re trading shares of company ABC at $40, the market moves downward – $38, 37, 36… When placing your order, you set a stop-loss at $37, this means your trade closed at $37 and you avoided losses of further falls.
Unlike our example, however, setting a stop-loss is not always so straight forward. For a more in-depth overview of how to make stop-losses more efficient, while minimising your risk, read our article on how to make stop-losses work for you.
Let’s look at take-profits. Like stop-losses, these types of orders help prevent you from taking unnecessary trading risks. Take-profits work by ending your trade at a pre-set level.
For example, you’re again trading shares in company ABC at $40. This time instead of falling the price continues to rise $46, 47, 48, before taking a sharp plummet to $38. The take-profit you set at $47 meant your trade closed at this price and you avoided the drop to $38 that followed.
Setting take-profits works by helping you avoid such sudden market drops. It’s also an effective tool for tackling excessive greed in your trading, which may cause you to risk more.
Technique 3: Practice makes perfect
We hear it time and time again – practice makes perfect. But how do you get real trading practice, build your skills and knowledge, without making a significant dent in your pocket?
A common risk mitigation strategy is making use of your broker’s demo mode,which allows you to try out what it’s like to be a ‘real’ trader without risking any of your funds. Armed with virtual money you can try trading on a variety of markets, explore how charts work, and get to grips with the ins and outs of your chosen trading platform.
Demo accounts also lets you test out trading strategies and find one what works for you. By practicing with the platform you plan to use, you reduce your risk of making ‘silly’ mistakes, such as not knowing which button does what. This allows you to concentrate on what really matters – your trading strategy.
Your risk management plan
Now, that we’ve uncovered the three key risk management techniques for your trading risk management, you’re well on your way to managing your risk as a trader. The final and most crucial point to risk management is your personal appetite for risk. Every trader will have their own level of acceptable risk, that is tuned to their expectations and personal finances. Before trading, it is important for a trader to define what is an acceptable level for them, and then stick to it to avoid unanticipated losses. No matter what your risk appetite is, don’t forget trading is risky.