Risk management: Controlling your exposure in trading
Risk is an inherent part of trading. The possibility of losing money is always present, and every decision a trader makes carries with it some level of risk. However, traders today have a suite of tools available to help them manage their risk and control their exposure. In this article, we will explore the different types of risk that traders face and the steps they can take to develop a comprehensive risk management plan.
What is risk in trading?
Risk in trading refers to the potential for a trade to result in a lower return than expected. This could happen for several reasons, including having to close the trade below the profit target or losing all the capital invested in the position. Every trader makes mistakes, which is why it is crucial to have a plan in place for managing risk.
Types of risk in trading
There are three main types of risk that traders need to be aware of: market risk, liquidity risk, and systemic risk.
- Market risk
Market risk is the most common type of risk that traders face. It refers to the possibility that a trade will earn less than expected due to adverse movements in market prices. One way to control market risk is to understand the unique factors that drive prices on the assets you trade. If you are buying stocks, for example, you should learn the effect that interest rates, forex prices, and more might have on the companies you are investing in. Using stop losses and take profits can also help control market risk.
- Liquidity risk
Liquidity risk arises when a trader cannot exit a trade as quickly as desired. This can hurt profits or lead to a loss from the position. Liquidity risk is less of an issue when trading CFDs or forex with a market maker such as FOREX.com, as traders do not own the assets in their accounts and do not need to find a counterparty for each position.
- Systemic risk
Systemic risk refers to the chance that an issue with the wider financial system will hurt a trader’s bottom line. A classic example of systemic risk is a global market crash, where stocks and indices around the world tumble, with subsequent impacts on other assets. Diversification is a common method of mitigating systemic risk. By spreading trades across multiple asset classes and economies, traders can protect themselves if a crash arises.
Developing a risk management plan is crucial for traders to control the various types of risk they may encounter. The plan should cover the exit strategy, position sizing, and how to pick opportunities. A comprehensive risk management plan can help traders avoid common mistakes and minimize potential losses.
The exit strategy is an essential part of the risk management plan, and traders should know the maximum loss they want to risk from any single position. Consistently allowing losing trades to go beyond this point can lead to failure. It is recommended to decide on the maximum loss before entering any position and staying disciplined about exiting any market if it hits that level. One common mistake among traders is to hold on to losing trades in the hope that they will turn around, which can be avoided with a good risk management plan.
Position sizing is another crucial aspect of the risk management plan. Traders should decide how much capital to allocate to each opportunity ahead of time. This can help them control and quantify their risk. It is a good idea to determine a proper position size according to the size of the account. By paying attention to the sizing of their positions, traders can avoid significant losses.
Instead of rushing into new positions, traders should weigh and consider opportunities carefully. They should create a detailed trading plan as part of their preparations and stick to it. Avoiding entering into any trades randomly or haphazardly based on emotions such as excitement, greed, or fear can be beneficial. The fact that a market is rapidly moving in one direction or another may not constitute a rational reason for getting into a trade.
In addition to the above, traders should also remember the following key points:
- Trade with the prevailing trend – considering the path of least resistance and going with the flow of the current market.
- Establish a detailed strategy for entering and exiting trades – defining parameters for getting into and out of trades without ambiguity.
- Watch downside risk and be prepared to act decisively – ensuring discipline in preserving the account to live to trade another day.
- Trade with reason, not emotion – avoiding the influence of human emotions like excitement, greed, and fear.
- Avoid trading around scheduled news events – markets can become more volatile around news events, meaning prices may move drastically within short periods.
In conclusion, risk management is an essential part of trading that can help traders control the various types of risk they may encounter. A comprehensive risk management plan covering the exit strategy, position sizing, and how to pick opportunities can help traders avoid common mistakes and minimize potential losses.
