Coronavirus has had severe implications for the world’s economy and financial markets. Many businesses, from small restaurants to large luxury cruise lines, have closed while most people around the globe are forced to stay at home. In the United States, the number of people filing for unemployment claims has risen to unprecedented levels, with some economists predicting the worst is yet to come.
Meanwhile, volatility in the market as measured by the VIX Index (VIX) has jumped to the highest level since 2009.
Therefore, risk management has become an essential component for traders. In this article, we will look at why risk management in trading is vital, as well as present six trading tips that might help you to minimise risk in today’s unpredictable markets.
Why risk management is important for modern traders
Risk management is the practice of identifying potential risks and mitigating them to prevent significant losses. While the strategy is always vital to traders, its role has become even more essential during the current Covid-19 pandemic.
Why? The answer lies in increased levels of volatility. For example, the S&P 500 (US500) rose by more than 50 per cent from January 2017 to February this year. However, the index has pared most of those gains in less than a month now.
The importance of risk management in trading is that it helps you minimise losses you can make per trade while maximising your returns. Additionally, it will give you peace of mind knowing that your exposure to potential risks is minimal.
An excellent example of this has been reported widely in the press. As the crisis started, Bill Ackman, a hedge fund manager, hedged his portfolio by buying credit protections worth $27m. Although his portfolio dropped, the value of his hedges ballooned to more than $2.6bn. In this case, his risk was just $27m and his potential profit remained unlimited.
Six trading tips to help you survive the market's madness
Capital.coms’ chief market strategist David Jones has made his own list of six essential trading tips that every modern trader should know to better weather the latest market’s turbulence and minimise their losses.
Let’s review each of them in detail with some real-life examples.
The size of your position can determine how much money you make and how much you lose. For example, if you have a $1,000 account, it means that you can buy about 193 shares of Ford (F), which are trading at $5.17. If the stock rises to $6, your profit will be about $158, which is a substantial return. However, with volatility rising, the stock could also drop to $4.34. In this case, your loss would be about $162.
Therefore, a proper position sizing strategy can help you minimise this type of loss. A good rule to use is to ensure that each trade risks a maximum of 3 per cent of your account. In this case, with your $1,000 account, you should ensure that the maximum loss per trade is about $30.
You can tweak the size of your positions by changing the size section as shown in the chart below.
A stop loss is an essential tool to use, especially in times of increasing volatility. It stops your trade immediately once it reaches a predetermined level. In the aforementioned example of Ford, you would put a stop loss where your maximum loss is $30.
Nonetheless, you should use your stops carefully and consider the size of intraday movements when trading during the virus pandemic. A perfect way is to widen your stops to prevent your stop loss from being triggered so soon.
For example, in March, the Dow Jones Industrial Average (US30) made its biggest single-day loss of 2,997 and its biggest single-day gain of 1,985 points. On average, the index lost and gained more than 500-points every day. Therefore, you would have increased your chances of losing money if you placed a stop-loss at about 50 points. The chart below shows how daily price ranges increased in March as the coronavirus pandemic spread.
Most traders use leverage to maximise their returns. Higher leverage often leads to bigger profits. However, the tool is a double-edged sword, meaning that it also exposes you to a more significant loss.
Here's a real-life example. You have $1,000, and you believe that the stock price of Ford will move to $7, so you buy 193 shares. If the price reaches $7, your profit will be $353. If the price drops to $4, your loss will be $228.
Alternatively, you can decide to use leverage and borrow an additional $1,000. In this case, you will buy 386 shares. If the price reaches $7, you will make $2,700. After returning the $1,000 to the lender, you are left with a profit of $700. However, if the price drops to $4, your stock will be worth $1,544. As such, you will have just $544 or a loss of $456 after you return the borrowed cash.
It is possible to lose more money than you have invested when you are using leverage. While Capital.com’s trading platform offers negative loss protection, we recommend that you adjust your leverage to prevent outsized losses.
Monitor open positions
A lot of activity is happening in the financial market during the current crisis. More action is expected to take place in April when companies start releasing their quarterly results. Therefore, monitoring your trades often can help you react to incoming news faster.
Capital.com has two features that will help you to always stay on top of the latest market developments. First, our platform is available on both desktop and mobile. This helps you monitor your positions wherever you are.
Second, we have an alert system, which will send you a notification once your target price is reached. For example, at the time of writing, the BTC/USD pair was trading at 6,090. You could place an alert so that you are notified when the price drops to 6,070, as shown below.
Close before weekend
News is very essential during this period of a global pandemic. To stay safe, we recommend that you have access to the best news sources. This access will help you act faster when news breaks. In addition to this, we suggest you close your trades before the weekend.
A good example is what happened in the second week of March. On that Monday, the price of crude oil opened 30 per cent below its close on Friday as shown below. This is because Saudi Arabia announced that it would increase its oil production and lower its prices. As a result, traders who were long on crude oil on Friday lost a significant amount of money on Monday.
Therefore, we recommend that you wind-up all your positions before the market closes on Friday. In most instances, we also suggest closing positions every night to avoid overnight risks that are similar to those of the weekend.
There are two primary types of orders you can place in the market. A market order is one that is executed immediately at the current prices. A limit order, on the other hand, is one that is executed at a later time and at a predetermined price. For example, you can open a limit order that will buy BTC/USD when it hits 6,070. When setting the price, you can also set-up a stop loss and a take-profit for the trade.
The benefit of limit orders is that they help you trade even when you are not in front of your computer or smartphone. Also, with so much news coming in, the limit orders will help you open multiple trades in different assets when such opportunities emerge.
The bottom line
The Covid-19 pandemic has brought volatility back into the market. While this volatility helps traders make more money because of the high swings, it can also lead to significant losses.
The online trading tips highlighted in this article can help you minimise those losses when trading during this virus pandemic.