Risk Management in Trading Explained

Overview

Life consists of many risks that cannot always be eliminated or avoided, and for this reason, there are certain risk management controls in place. Trading in the financial markets works the same, where traders are exposed to several different risks.

When traders start to trade, they need to develop an approach towards trading that consists of effective risk management to help them navigate the markets, earn a profit, and minimize their exposure to losses.

Introduction to Trading

Trading refers to the process involved with exchanging a good, service, currency, or any other object of value between either two or more people. Trading started with simple bartering systems where tribes would exchange commodities to obtain items that they needed.

While risk could be handled physically during these times, based on what people knew and could physically see, it became increasingly harder with the introduction of electronic systems and the use of the Internet to trade with other countries and market participants.

Apart from these inherent risks, there was another hidden risk that many traders could not see until it may have been too late. Because of the speed at which transactions are executed, instant gratification when earning a profit, and the adrenaline rush involved, many traders are likely to succumb to a gambling instinct.

This causes many traders to consider trading as another form of gambling as opposed to considering it as a professional business that demands the right speculative habits and a strategic approach.

Traders who speculate on the price movements of financial instruments are not gambling. The difference between gambling and trading lies in the use of risk management when trading financial markets.

When they speculate, traders have a certain amount of control over the risk that they are exposed to, and they can use different ways to minimize their exposure where they have no control, which is why it is different from conventional gambling.

Different Types of Risk in Trading

There are several different risks that traders must familiarize themselves with before they start trading, these are as follows.

Counterparty Risk

This relates to any problems that may emerge from the broker or the bank that the trader uses to facilitate their trades. It can also relate to the liquidity provided by the facilitator and the financial institution’s ability to meet its end of the transaction.

Leverage Risk

Leverage is a useful tool that can be used in several financial markets, it allows traders to open positions that are larger than their initial deposits, allowing them to make significant gains.

However, while leverage can amplify the gains that traders can make, it also amplifies the risk of loss in addition to the realized losses. When traders participate in margin trading, it means that they are exposed to more risk with every trade, which is why leverage must be used correctly.

Interest Rate Risk

This refers to the sudden increase and/or decrease of interest rates, which will inadvertently affect volatility in the market. Interest rate risks can apply to forex trading because of the level of spending and investment in the economy, which increases and decreases depending on the direction of the rate change.

Currency Risk

This relates to currency prices which fluctuate because of several different driving factors such as economic situations, earnings releases, news, and several others. When this happens, the transaction costs can increase or decrease accordingly, which means that traders can either pay more or less than the quoted price.

Risk of Ruin

This risk is one of the main reasons why risk management is emphasized as it involves the fact that traders have finite supplies of capital that they can use for trading. If traders speculate correctly and the market moves in their favor, it can take longer for the market to reach a point where the trader can start profiting.

With limited capital, the trader can run out of funds, and they will be unable to sustain the trade. Traders must ensure that they place their stop-loss and take profit orders at the appropriate levels to avoid such a risk.

Traders must also have a solid trading plan in place that indicates their exit points, which will save them if they are in a losing trade and the market either turns against them, or it will not be profitable to keep the position open while waiting for the market to reach a certain level.

Market Risk

This refers to the overall market conditions that traders face every day when they trade. It also refers to the risk that the market can turn against the trader, or it can start moving in a way that the trader could not have anticipated in their technical or fundamental analysis.

Many factors determine the price movements and direction of the market and while no tool can predict it accurately, viewing historical price charts can help traders anticipate price movements under certain conditions, indicating potential trading opportunities for certain instruments once the market conditions are right.

Operational Risk

Operational risk refers to the risk of internal or external systems failing such as the trader’s Internet connection, trading terminal or platform, and so on.

Liquidity Risk

This refers to risks with low trading volumes in a financial market where traders will not be able to close their trades as there is a lack of buyers/sellers in the market. Fortunately, this is not an issue in the forex market, which is the most liquid financial market in the world.

Knowing the Odds before trading

Before traders open a position, they must consider all the factors that will determine their odds of success in the market, based on several principles, and what they can do to protect themselves while trying to earn a profit.

This involves an extensive evaluation and analysis of the financial market in which the trader is participating through either of the following:

• Technical Analysis – which considers the where, how, and when of trading in financial markets by identifying the best trading opportunities. This analysis considers several components including trading volume, price history, trends, and several others using price charts and a variety of technical indicators, tools, and simulators to play out different scenarios.
• Fundamental Analysis – evaluates the financial instrument being traded relating to certain information such as news, financial statements, industry conditions, and several other components, used to calculate the intrinsic value of the instrument.

While traders have a choice between the two, most experienced traders will often use a combination of both to produce a comprehensive and in-depth market analysis, which is ideal for making informed, calculated trading decisions.

When traders want to participate in a certain financial market, they must also study the dynamics of the market, using different price charts to identify any psychological price trigger points.

When traders decide on where they must enter and exit the market, they need to consider the appropriate controls they need to implement to minimize their risk exposure. Traders must then accept the risks that they are exposed to before they enter a position.

When traders can accept these risks and are comfortable with their willingness to be exposed to risks, they are trading responsibly and strategically without the risk that their emotions will direct their decisions.

If traders are unable to accept the risks that they are facing on a particular trade, it is a clear indication that they should not open the position but take the time to re-evaluate their instrument of choice, the market conditions, their trading skill,s and trading plan, and other factors that may be causing this problem.

Different ways to bet while trading

There are three distinct ways to make a bet, these are:

• Martingale
• Anti-Martingale
• Speculation

Martingale

Traders who use this strategy double their bets every time they lose. With every bet, they hope that the next trade will be a winning trade, that their losing streak will end, and that they will win a trade and recover what they had lost.

This is one of the misconceptions that traders have going into the financial markets, and it is a strategy that will have dire impacts where traders can lose all their capital.

Anti-Martingale

With this strategy, traders would halve their bets once they lose a trade and double up once they win. This allows the trader to capitalize on winning streaks as well as profits.

This is the lesser of two evils between these two trading strategies as it is not as risky. Traders accept their losses and they do not allow them to deter them, and they add or increase their trading size when they experience a winning streak.

However, the typical rule of thumb in risk management is that traders try to keep their risks constant. By increasing the trading size, traders are exposing themselves to more risk with no way of knowing whether they will win or lose.

Speculation

When traders speculate, they believe that the price of a financial instrument will increase, and they enter a long/buy position based on their technical and fundamental analysis. When the trader believes that the price will decrease, they enter a sell/short position intending to buy the instrument back at a much lower price.

The Role that Liquidity Plays

In covering liquidity risk, traders can begin to understand how important liquidity in a financial market is to execute trades. Liquidity refers to the number of buyers and sellers in the market, which is what makes it possible to buy and sell instruments at the best prices before they fluctuate.

The forex market is the most liquid financial market because of the sheer daily trading volume that it experiences, especially with the major currency pairs such as EUR/USD, USD/JPY, GBP/USD, USD/CHF, AUD/USD, USD/CAD, and NZD/USD.

The market liquidity that is present in the market may not always be available at the same level to all participants in the market such as brokers. In addition to this, liquidity for major currency pairs will not be the same for other pairs as there are fewer buyers and sellers.

The liquidity of the broker is dependent on several components including the business model of the broker, whether Dealing Desk or Non-Dealing Desk, and whether they use Straight-Through-Processing (STP), Electronic Communications Network (ECN), or Direct Market Access (DMA) execution.

In the case of Dealing Desk, or Market Maker brokers, market liquidity is not a factor as these brokers provide liquidity for their clients as they are the seller or buyer in a transaction.

Risk Per Trade

Traders must consider the amount of capital that they can put towards trading, and how much of this they can comfortably risk losing. No trader actively wishes to lose capital, but it is something that can happen, even if the trader uses all the risk management at their disposal.

The purpose is to minimize as much loss as possible and one way is to keep their risk per trade as low as possible. Traders should not risk more than 1 – 2% of the capital in their account. If the trader has R5,000 in their trading account, their maximum loss allowable must not be more than 2%.

This means that the trader must not risk more than R100 per trade and with this percentage, it means that the trader can afford to lose 50 times before their account is depleted of funds.

Even though such a scenario is not likely, traders can lose consecutive losing trades by using a sold trading system that has been developed to try and stack the odds in the trader’s favor.

Using Leverage when trading

Leverage is one of the most useful tools across several financial markets, allowing the trader to borrow from their broker to open large positions despite their initial deposit. One of the most leveraged markets is the spot forex market, which allows traders the use of significant leverage ratios.

If traders fund their account with R1,000 and they apply a leverage of 100:1, traders can easily open a position worth R100,000. If traders experience a 1-pip loss on this trade, it means that they would have lost R10.

If the trader opens a position size of 10 mini lots, which is 10,000 units of the base currency, and they experience a loss of 50-pips, the trader would have lost R500.

Fundamentals of Trading Risk Management

Education

The first step that all beginner traders must take before they start trading in any financial market, is to learn about the basics of trading. Traders can never learn enough, and even experienced traders still learn new things every day.

There are many educational sources available and there are many forex brokers that offer educational materials and tools to their traders, which are often free to use.

Demo Account

Once traders have covered the basics, they can put their theory to the test by registering a demo account with a broker. The demo account will give traders a perfectly mirrored trading environment with real-time prices and movements, access to financial instruments, and different tools, but their capital will not be at risk.

Traders can participate in the market using virtual funds, giving them the perfect opportunity to learn in a practical yet safe manner until they are ready to register a live trading account.

Risk Appetite

Risk appetite refers to the trader’s exposure to risk, willingness to be exposed to risk, and whether they can afford to be exposed to certain levels of risk. To determine their risk appetite, traders must determine how much they can comfortably lose in a single trade.

A good rule of thumb that traders can use is that they should never risk more than 1-2% of the capital in their account. On an account of R1,000, that means that traders can lose between R10 to R20, which may not seem like much, but keeping to this, traders will enforce discipline and avoid becoming greedy.

Position Sizes

Position sizes can refer to the trading volume or the number of lots that the trader buys or sells. Choosing the right position size can protect traders, especially beginners, against significant losses. There are many online calculators provided by brokers that provide traders with a tool to calculate the correct position size.

Stop Losses and Take Profit

These levels are powerful risk management tools, and their placement can be determined through fundamental and technical analysis. Traders can use Moving Averages or by using the support and resistance trend lines while considering the following:

• Long-term Moving Averages must be used for volatile financial instruments.
• Moving Averages should be adjusted until they match the target price ranges.
• Stop-losses should not be closer than 1.5x the current volatility.
• Stop losses should be adjusted according to the volatility of the market.

In addition to these useful tools that traders must use with every trade, traders must familiarize themselves with Risk-Reward Ratios (RRR), which help many traders with sustainable profitability.

RRR measures and compares the distance between the entry point and the first stop-loss and take profit. Traders who use day trading strategies such as scalping must aim to have a 1:2 RRR, which means that reward is twice the risk. Swing traders, trend traders, position traders, and other longer-term traders should aim for 1:3 where the reward is thrice that of the risk.

Controlling Emotions

Trading psychology is a component in trading that traders must familiarize themselves with. Traders must understand their psychology, their stress factors, triggers, weaknesses, and strengths before they can start trading.

By knowing what type of trader they are, traders can include their trading psychology and how to manage it in their trading plan.

Realistic Profit Expectations

Traders have different reasons why they want to trade, and they also have different expectations where profits are concerned. Despite what traders aim to achieve, they must have realistic profit expectations as it can influence trading.

Traders who have realistic expectations will practice the patience that is required to become a successful trader. In addition to this, these traders will also have a lot more disciplined, and they will be focused on sustainable profits and not quick funds.

Trading Plan

The trading plan is an important component as it is based on a predefined set of rules unique to the trader and their situation. Traders must have a strategic approach to trading, and they must have a tested trading strategy that outlines:

• Entry points
• Exit points
• Minimum RRR
• Risk Appetite and the capital that the trader can afford to lose

Prepare for the worst

Even the most experienced traders cannot predict what the market conditions will be on the next trading day. However, there is evidence-based historical performance that may give some tell-tale signs of how the market will react in certain situations.

Expected Return

Traders need to set their stop-loss and take profit levels, but to do this they must calculate their expected return. By doing this, traders can think their trades through and determine whether the trade is worth it.

Traders can also use this information to compare different trades to choose the profitable ones. When calculating expected return, traders can use this formula:

[(Probability of Gain)] x (Take Profit % Gain)] = [(Probability of Loss) x (Stop-Loss % Loss)]

Diversification and Hedging

Diversification

Diversification, as the name suggests, involves the trader diversifying their investment and trading portfolio by investing in more than just one financial instrument. This helps to manage risk and it also opens traders to more trading opportunities.

Hedging

Hedging is a trading strategy that traders can use across different financial instruments to secure their position at a certain market price, exempting them from being susceptible to exchange rate changes of price movements.

Keep Risk Consistent

Traders need to consider their trading plan and the fundamentals thereof before they increase their position size. With larger trading volumes, traders will face more risk and they may not be ready to face this without the required experience.

Traders must adjust their trading volumes according to their trading experience and their trading objectives and needs, ensuring that they still protect themselves while they advance in their trading journey.

Consider Currency Correlations when trading forex

Forex traders need to ensure that they understand the fundamentals of currency correlations as it could expose them to several risks. Correlations can either be positive or negative, and it refers to how the price of one asset will change according to another.

If two currencies are positively correlated, they tend to move in the same direction, while the opposite is true of negatively correlated assets. When traders consider correlations, they must remember the following:

• Be cautious when dealing with commodity currencies
• Avoid opening several positions that could cancel one another out, especially with some currency pairs.
• Avoid opening positions that contain the same base currency or quote currency, for instance, EUR/USD, AUD/USD.

FAQ

What is the difference between money management and risk management?

Money management refers to how the trader handles their capital while risk management refers to a system that has controls for each risk that could affect trading.

What is a trading strategy?

It defines a system that traders use to determine when to buy and sell a financial instrument.

How much capital do you need to start trading?

Different brokers have different minimum deposit requirements, with some lower than R14. However, traders must deposit enough funds to cover costs and fees and any potential losses.

Which trading strategy should I choose?

This will depend on the trading style of the trader, their risk appetite, experience level, and the financial instrument that they want to trade.

What is a “Lot” and which lots can I trade?

Lots can be defined as a unit measuring a transaction amount or position size. A standard lot is 100,000 units of currency, while a mini lot is 10,000, micro is 1,000, and nano is 100 units.

How can you avoid risk while trading?

You cannot avoid risk when you trade, but you can understand the types of risks that you can expect and manage your risks accordingly.

Is trading profitable?

Yes, trading in any financial market can be profitable depending on the trader’s plan, strategy, experience, knowledge, and several other factors.