Managing risk is the process of identifying, quantifying and attempting to reduce the uncertainty that comes with trading and investing. It’s a well-known fact among successful investors that operations with high potential rewards also carry a lot of risk. Such risks are especially true for CFD markets. Risk management is the process by which traders hope to reduce the inherent risks of their positions.
The large volumes of transactions within derivative markets provide great opportunities for forex traders to make profits. However, many potential opportunities to profit also mean many opportunities for losses. To be a successful trader, you must learn how to manage the risks of your trades. This way, you can avoid losing all of your funds quickly.
The basic premise of managing risk is the idea that no trade should be open forever. Once conditions change in a certain manner, you need to close each trade sooner or later. We’ll explore the basics of how and where in this article.
Tools for managing risk
Arguably the most important part of successful management of risk is setting stops. Stop loss (usually just called a ‘stop’ by traders) is a function in most of the popular trading platforms. It works by closing trades automatically at a certain level, usually in loss. You can move a stop by entering a new number if desired. This includes moving stops into profit to protect rolling profits. The idea is that stops prevent trades from being unnecessarily bad, because without a stop the loss from any one trade is theoretically unlimited unless you close it manually.
In this example, the stop (the red dotted line) has been moved up to protect a rolling profit. The trader has placed their stop slightly below the extent of the latest retracement on this chart. Click on the image to magnify.
Many traders also use a trailing stop. In MT4 and MT5, this functions similarly to a normal stop. The exception is that it follows price in the direction of profit by a particular number of points, so it’s only activated and triggered in profit. Using a combination of normal and trailing stops can be a very effective tool to avoid the worst losses.
The final key function of the platform for managing risk is take profit. Usually called a ‘target’, this allows traders to determine a point in profit where a trade will be closed. For new traders, targets are the essential counterparts to stops. Used together in the correct way, they allow beginners to cut losses and let profits run more easily.
The process of managing risk
Apart from these technical functions, putting management of risk into practice basically means staying in control of your emotions. This is one of the key skills for becoming a successful trader in the future.
There is no perfect strategy for trading and every trader makes a loss on some trades. To be a profitable trader, you must know when to close a losing trade. You must not incur major losses that could drastically deplete your account.
A trader should not stubbornly hold a losing trade. Instead, they should try to cut their losses quickly. The same reasoning though in reverse applies to profitable trades. Most new traders find it difficult to hold a good trade, instead closing profitable trades prematurely before the main movement is complete.
Stops and targets as part of a strategy
The concept of the ratio of risk to reward is critical. This is the idea that the potential profit from a particular trade needs to justify the potential loss. Many experienced traders recommend a ratio of at least 1:2, and this is the most common ratio among newer traders as well.
For example, let’s say that a trader using this ratio buys EURGBP at 0.89990. Their target is 0.90190 and their stop is 0.89890. This means that the potential profit is double the potential loss, giving the trader an edge as compared with closing randomly whenever they feel like it.
It’s difficult to overstate the importance of a positive ratio of risk to reward for new traders. Without this, you need more profitable trades than losing ones overall, in some cases significantly more. With a 1:2 ratio, though, a trader could be wrong about direction more than half the time and still make a limited profit in total.
Practical management of risk
Generally speaking, ratios are theoretical ideas which aren’t adhered to exactly in practice. This is because a certain set number of points from the current price for a stop is almost never a significant technical area.
The twin concepts of support and resistance are the basis of stops and targets for most traders. This usually means that traders err on the side of a higher ratio than exactly 1:2. Support and resistance are discussed in the article on technical analysis. The concept isn’t very difficult to understand but it’s key to mitigating risk: learn more by reading our article introducing technical analysis.
In this example, a trader’s selling AUDNOK and has a ratio significantly higher than 1:2. The stop is the red dotted line slightly above the price and the target is the other red dotted line somewhat below the price. The ratio here is actually more like 1:4.5. The reason for this is that setting the target exactly double the distance from price of the stop will result in placement of both in areas that’re technically insignificant. Click on the image to enlarge.
Some traders are inherently more conservative or more aggressive than others when it comes to how much more than 1:2 they use for their ratio in practice. Nearly all of them though abide by an important general principle: if the appropriate technical placement of your stop would mean you’d lose too much money if it was triggered, you need a smaller trade, not a closer stop.
Patience in managing risk
Many traders start with the hope of making a lot of money in a short period of time. In reality, this is almost impossible. Unless you have a very large deposit in tens of thousands, CFDs are only a way to make a decent additional income at best.
Impatience often causes traders with unrealistic expectations to risk more money than they can afford to lose. As a trader, you must never do this. You should also never borrow money to trade and never trade with money you need for your daily living expenses.
Greed, arrogance and ignorance are the unholy triumvirate for new traders. These emotions have caused many otherwise intelligent people to lose money by trading. Starting with a demo account is essential for the development of a strategy to manage risk. After this, it’s also critical to start slowly and with small amounts when it comes to trading with real money. At all times, you should be able to admit that you were wrong if need be and reconsider your strategy.
Managing risk: the last word
As you’ve discovered, trading has a high likelihood of causing you to lose money if you’re reckless and unprepared. This article is probably the most important of all the information in Exness Academy for avoiding that. We recommend more than usual that you reread this article and try the short quiz below. Once you’re confident that you understand the ideas here, you might consider moving on to technical analysis.
Test your knowledge by trying this short quiz.
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In terms of popular trading platforms, what’s a target?CorrectIncorrect
It’s reasonable to keep many trades open indefinitely if you can manage the risk associated with them.CorrectIncorrect
What’s the main difference between a normal stop and a trailing stop?CorrectIncorrect
Which is the most common ratio of risk:reward used by new traders?CorrectIncorrect