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Understanding Risk Management in Trading

BitForex Editor
Oct 29, 2020

When it comes to trading, risk management serves as one of the most essential topics you should be well knowledgeable about. If you are in the business of making money, it is crucial that you learn how to manage risk (potential losses) as it can help you to make more profits; however, in the areas of trading, this is one factor that is greatly overlooked.

Risk management doesn’t just help reduce losses; it also protects traders from losing their money. The risk, in this case, takes place when the trader experiences a loss, but once it can be controlled, the trader can easily open him/herself to making profits in the market. It is necessary to understand that without a risk management strategy, a trader can lose substantial profits with just one or two bad trades. The question to ask at this point is, how can this be avoided, and how can a trader develop the best strategy and technique to curb the risk of the market? While that is a vital question, it is essential first of all to understand what risk management is.

What is Risk Management?

Risk management revolves around the processes involved in assessing, identifying, and controlling possible threats to the capitals and earnings of an organization. These risks or threats could arise from various sources of strategic management errors, financial uncertainty, security threats, and data-related risks, legal liabilities, accidents, and natural disasters, amongst others.

Every business faces possible unexpected risk, harmful events that can affect the profits of the said business, and, in some cases, result in its shutdown or closure. Risk management provides the opportunity for businesses or traders to prepare for the unexpected by reducing risk and extra costs before they happen.

Why is Risk Management important For Traders?

With proper implementation of a good risk management plan as well as considering various potential risks or events before they happen, a trader or business can protect their profits and future. This is mainly due to the fact that a well-planned risk management strategy will help businesses put in place specific procedures that will help to avoid potential threats as well as reduce their impact if they happen and also help cope with the results. Understanding and controlling risks allows traders to be more confident in their business decisions.

How Risk Management Works

Risk is the probability of the actual return on investment deviating from the expected return. These deviations usually happen due to events during trade, and they vary in magnitude and direction. A favorable or profitable event may result in a positive deviation, which could attract more than the expected profits. In contrast, an unfavorable event could result in a negative deviation, which could cause incurring a loss, breaking even, or earning less than expected.

Events that influence the market tend to affect trading volume in terms of direction, size, position frequency, thereby creating a difference in the intensity of price fluctuations. This is referred to as “volatility.” The financial capacity, as well as the psychological resilience of a trader to endure high volatility, determines risk tolerance, so the higher the risk tolerance of an individual, the higher return potential such person is sure to get.

Risk Management Techniques For Traders

A smart way for traders to stay in the game is by having an objective as well as a strategic approach to risk management, which is why some of the best risk management techniques for active traders include;

Planning Your Trades

For traders, planning can often prove the difference between failure and success. It is necessary first of all to ensure that your broker is the best choice for frequent trading as some brokers cater to customers who trade infrequently, plus they don’t provide the proper analytical tools for active traders, and they usually charge high commissions. Two key ways that traders can plan when trading is by taking into account stop-loss and take profit.Successful traders are aware of what price they are willing to sell as well as the price they are willing to pay. They can easily calculate the result of returns against the probability of the stock hitting their goals before proceeding to execute the trade if the adjusted return is high enough.

Unsuccessful traders usually enter a trade without knowing if they are selling at a profit or loss. Similar to gamblers experiencing an unlucky streak, they allow emotions to control and dictate their trades. Losses usually make people hold and hope to make their money back, while profits in the same instance can also make traders hold on in the hope of making more gains.

Consider the One-Percent Rule

Some traders usually follow what is known as the one percent rule, which stipulates that you must never put more than one percent of your trading account or capital into just a single trade. For example, if you have 10,000 dollars in your trading account, you shouldn’t put more than 100 dollars into any single trade.

Setting Stop-Loss and Take-Profit Points

A stop-loss point is used to refer to a price a trader is willing to sell a stock as well as take a loss on the trader. This usually occurs when a trade does not go the way the trader had expected. The points serve the purpose of limiting losses before they escalate out of control as well as preventing the “it will come back” mentality. For example, traders usually sell a stock as soon as possible if it breaks below a key support level.

The take-profit point, on the other hand, refers to the price at which a trader will sell a stock as well as make a profit on the trade. For example, a trader may choose to sell a particular stock before consolidation occurs if the said stock is approaching a major resistance level after a big move upward.

Calculating Expected Return

Setting stop-loss and take-profit points are also essential for calculating the expected return. This calculation propels traders to rationalize as well as properly think through their trades. It enables them to select the most profitable trades after comparing various ones.

Diversify and Hedge

Making the most of your trading does not mean putting your eggs in one basket. Putting all your capital into a single stock means you are setting yourself up for a major loss. Practice diversifying your investments across both sectors of the industry, geographic region, and market capitalization. This helps you to manage risk as well as provide more business opportunities. You could also find yourself in a situation where you need to hedge your position. You can protect your position by considering taking the opposite positions through options. Plus, you can unwind the hedge when trading activity subsides.

When applied, risk management provides numerous benefits for traders, including improved success rates and increased profits. Successful traders today trade with confidence due to implementing an effective risk management strategy, which eliminates the possibility of business and profit loss.

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