How to Apply Risk Management Strategies to Mitigate Trading Risks
Trading by its very definition is a risky undertaking. The moment you buy an underlying security, market forces can determine what happens to your trades. In the absence of risk, all outcomes are 100% certain. Currency markets, equity markets, and commodity markets are subject to market forces with varying degrees of risk. If you were offered the opportunity to triple your money by loaning somebody AU$100, would you do it? Many traders would be tempted, and risk AU$100 in expectation of generating an AU$300 return.
Perhaps it's worth explaining what risk is, and how it impacts the outcomes of your trading activity. In layman's terms, risk is simply that which is unknown, unpredictable, unforeseen, or uncertain. When you trade financial instruments listed on the ASX, or mFunds at CommSec, or your favourite online broker, you run the risk of loss. The question is not how much you stand to lose, but rather how to mitigate that risk through intelligent trading decisions.
As a trader, you invariably understand that markets rise and markets fall. That's one aspect of trading risk. However, it is entirely possible to profit off rising or falling markets, provided you make the right trades. A great way to guard against the ravages of trading risk is to set a goal and work towards it. Everyone has a different appetite for risk – that's what makes us unique as traders. There is a big difference between being an action junkie who is prepared to risk everything, and an individual who bases trading decisions on their merits.
Each of us pursues a growth strategy. These include aggressive growth strategies, moderate growth strategies, or low-growth strategies. These decisions are largely determined by what individual traders consider an ‘appropriate level of risk’ based on individual circumstances. There are generally two types of traders: risk-averse traders and risk-seeking traders. These terms define your appetite for risk. Generally, the younger we are, the more risk we are willing to take on. As we get older, our investment timeframe changes, and we tend to become risk averse. What type of trader are you? Are you risk-seeking or risk averse?
What Types of Trading Risks Are Out There?
Whether you’re trading indices, commodities, forex, shares, or cryptocurrencies, you are going to come up against a formidable selection of risk factors. Risk spans the full spectrum of Trading Risks, Investment Risks, and Market Risks. Traders who believe they can control the market are in for an unwelcome surprise.
Market forces are considerably more powerful than the most daring actions of speculators and institutional traders; they are the tectonic plates in the Earth's crust that send shockwaves across the land and the ocean, causing paroxysms of activity, in demand, supply, and pricing. Successful traders understand the art of risk management. By employing risk management techniques, you can mitigate the effects of these three categories of risk.
Let's briefly explore each of these risk factors and cobble together a trading strategy that works for everyone:
- Trading risks – your trading risks increase as you trade more. Trading risks include poor execution risk, slippage risk, and gap risk.
- Investment risks – these risks are dependent on your entry/exit points in trading activity. If your investment portfolio is too concentrated, it can rise or fall based on the performance of your concentration of investments. The greater the diversity, the more balanced your portfolio. Opportunity risk describes the opportunity cost of setting money aside for investment purposes when you could be generating alternative income streams.
- Market risks – markets are subject to whipsaw activity. They are volatile, unpredictable, and inherently risky. Three risk factors impact the financial markets, notably currency translation risk (based on currency differentials), inflation risk (the real purchasing power of your money), and marketability risk (how liquid your investments are).
The Elixir for Trading Risk: How to Minimise Your Risk of Loss
If trading risk represents the unknown, then strategic planning is the process by which we try to understand what we are up against in the markets. Most every trading guru worth their salt will advise you to carefully plan your trades before you execute them. By planning the trade, and trading the plan, it is possible to minimise the impact of the risk on your trading activity. Fortunately, there are several important rules to abide by. These rules will reduce your overall exposure to risk so that you don't get undone by a wrong-un.
- Stop-Loss and Take-Profit - Nobody wants to lose money on a trade. But, if your trade is losing money it's important to set a stop-loss point to sell the financial instrument before it wipes out your entire investment. Stop-loss points guard against the oftentimes flawed psychology that trades will bounce back. Take-profit price points are equally important because they guard against greed. Too many traders expect their shares, commodities, indices, and currencies to continue rallying ad infinitum. This is simply a fallacy. If bullish sentiment is limited by certain factors such as slowing demand, alternative technologies, economic downturns et cetera, it makes sense to take profit before a price reversal.
- The 1% Rule - Let's say you’ve got a trading budget of AU$10,000. How much should you place on any individual trade? The experts advise just 1% per trade. Given this rule, the maximum risk that you will be exposed to on any individual trade is AU$100. That's hardly enough to break the bank if markets sour. You may have a much bigger trading budget at your disposal, perhaps AU$100,000. If so, you may wish to up the 1% limit slightly. If you decide upon 2%, each trade will be no more than AU$200, or 2% of your trading budget.
By adopting the aforesaid strategies, you will avoid risk of ruin completely. Risk of Ruin refers to the probability of losing so much of your trading budget that you will no longer be able to continue trading. Fortunately, it’s impossible to face Risk of Ruin if you stick to the 1% rule, and apply Stop-Loss and Take-Profit strategies.
Trading Risk and Day Traders
If you decide to dabble in day trading, it's important to stick to the 1% rule listed above. The objective of day trading is simply to win more trades than you lose, with a caveat. If you are winning 60% of your trades and losing 40% of your trades, you would be considered a successful trader on paper.
However, the size of your losing trades matters just as much as the ratios. If 60% of your winning trades net you AU$12,000 and 40% of your losing trades cost you AU$13,500, the percentages don't matter as much. That's why it is important to stick to trading rules so that there is congruence between win/loss ratios and profitability.
Position size is critical with day trading activity. In fact, experts roundly agree that position size is way more important than your entry/exit points. You need precisely the right amount of risk to maximise your gains and minimise your losses. Some day traders prefer to allocate an AUD sum of money to each trade, while others prefer a fixed percentage. When setting stop-loss and take-profit, these levels must be carefully plotted out to ensure that prices actually have an opportunity to move before the trade closes out.
If you are prepared to lose AU$0.10 per trade and you have AU$200 available for each trade, the number of shares in your position size is AU$200/AU$0.10 = 2,000 shares. Now that's precisely how you blend your risk preference and your day trading strategies for the optimal approach to trading.
Wrapping it up: Trade with Confidence
Nobody wants to lose the shirt off their back in any trade, particularly when trading on gut instinct. When you step onto the trading wicket, limit your amount per trade to 1% or 2% at most, for perfect calibration. This doesn't eliminate risk, but it ensures that each fractional component of your portfolio can only effect losses on your portfolio of 1% or 2% of your original trading account balance, at most.