We get all sorts of “money management” advice from various trading crowds: “Don’t average down,” says one trader. “Always use a stop loss,” says another. “Don’t risk more than 2%,” say many others.
All of this advice falls under a category known as risk management. What makes these sayings useful is not always the advice itself but the context in which it is used. Some of these sayings are specific while others are left open to interpretation, such as “averaging down.”
What we’re going to do here is to further define risk management and to offer a few risk management tips that you might consider applying to your own active trading practice.
What is risk management and why is it important?
Risk management can be compared to a safety net used for acrobatics.
As an acrobat, your safety net doesn’t guarantee that you won’t get hurt or injured. It just significantly reduces your chances of getting splattered on the ground if you fall.
Risk management is the process for identifying and controlling risks to your capital. It’s important because the very essence of trading is to carry risk in the hopes of generating a larger return.
If you trade without proper risk management skills, it’s like taking on an acrobatic feat in high altitude without a safety net. One misstep and…splat.
What can active traders do to manage risk?
The key words in the question above is “active trader.” The reason for this is quite obvious: long-term investors often try to reduce volatility in their portfolio, typically by diversifying their assets. Active traders, on the other hand, prefer volatility to pursue short-term market opportunities.
Naturally, the kind of risk management strategies that active traders need to use may sometimes differ from those of long-term investors.
The stop loss is the most fundamental risk management tool you can use
If you’re losing money in a trade and exit your position, you may avoid taking a deeper loss if the market keeps moving against you. That’s the basic reason for using a stop loss.
But, did you get out too early? Did you place your stop loss in the right area? Was your stop loss appropriate for the size of your position? Are you getting stopped out frequently enough to sustain massive losses oin multiple trades?
As you can see, “using a stop loss,” however basic and important the tool, is still rife with risks. Be aware that there are instances in which stop losses may not trigger. In cases where the market is illiquid–either no buyers or no sellers–or in cases of electronic disruptions, stop losses can fail. And although stop losses can be considered a risk management (loss management) strategy, their function can never be completely guaranteed.
There’s more to risk management than just stop losses.
- Define your total loss limit: Failing to do so can be like misplacing your wallet and not being able to find it again. For instance, you can generate small profits and losses over time only to realize after a few years that you’ve lost a huge amount of money. Oops.
- Knowing when a trade is no longer valid is critical: If you can’t tell where (on a chart) a trade is no longer valid, you may be placing your stop loss at a highly disadvantageous position. More specifically, if you don’t know when your directional bias has been invalidated, then you run the risk of getting stopped out too soon, or taking a loss that could have been minimized.
- Follow economic releases and know which ones to watch out for: Do you know how often “market moving” reports are released? Might you have a sense as to which report might be more relevant than another based on the current economic context? If you want to manage your risks, you should familiarize yourself with these fundamental reports.
- Know how to size your positions to optimize potential profits while minimizing risks: It’s easy for a trader to say that he or she doesn’t want to risk more than 2% on a given trade. After all, using a Risk% (R%) strategy is one of the most potent risk management tools any trader can deploy. But it also happens to be one of the most misunderstood strategies in trading. Many traders have stuck to this 2% rule only to blow up their accounts. How so? They “mismanaged” this “risk management” tool (we’ll get to this later).
- Learn how to fractionalize your trades: Should you open a full position, a third, a half, or two thirds a position? It depends on the context. There are times when fractionalizing your trades can help you maximize your profit potential while minimizing your loss potential.
- For longer trades, know how to use options as a hedging instrument: If you’re going “long” for quite a distance, buying a comparable put option might serve as a solid safety net if the price of your asset plunges. But be sure you know how to calculate profit and losses when combining options and futures. Otherwise, you may end up netting a negative payoff.
These are all valid risk management strategies that can be useful, but the trick is in getting the measurements and the execution right. Keep an eye out for our upcoming blogs where we will go into more detail on different risk management strategies.
Please be aware that the content of this blog is based upon the opinions and research of GFF Brokers and its staff and should not be treated as trade recommendations. There is a substantial risk of loss in trading futures, options and forex. Past performance is not necessarily indicative of future results.