For any person learning to trade, risk management is one of the easiest topic to grasp. In fact, many learners tend to ignore this topic with a preference of learning more on technical and fundamental analysis technics. The truth is that risk management is an easier topic to cover than fundamental and technical analysis. That is the main reason why it is usually among the last topic to be covered by trainers of trading. However, it is the most important strategy one can learn in trading. Failure to grasp this concept will most likely lead you to make big losses. In this article, I will write more about risk management and cover a few ideas that can help you reduce your risk exposure.
First things first. Trading or investing in any asset is a risky affair. True, there are asset classes that are riskier than others. For instance, treasury bills in America and in other countries is always a sure investment. In addition, investing in penny stocks is similarly riskier than investing in mature blue chip companies such as Apple and Google. Another important thing you need to know about investing or trading is that there is no expert in the field. True, you will see ‘experts’ in Bloomberg and CNBC but the fact is that they do not everything they talk about. Many of them have interests that they want to drive forward. It is as a result of the risky nature of investing that all money managers, sell-side analysts, and brokers will warn you that your investment is not guaranteed. In short, past performance is not a clear indicator of future performance.
As a trader, you need to have a clear indication in mind of the amount of money you expect to make or lose in a trade. Failure to have this at the back of your mind will lead to immeasurable blunders. As stated above, in every trade you execute, you will either make a loss or a profit. Ideally, you should aim at having a 1.2 risk-reward ratio. This means that if you are to make $50 in a trade, you should be comfortable to lose $100. The opposite should not be the case.
Another strategy you need to follow is having a stop-loss order. This should specify the maximum amount you are willing to lose per trade. By using a stop loss in a trade, you will be at a good position to move out of a position where you have many winning trades but a single trade erases your gain. In addition, you should have the habit of using trailing stops to lock in profits. Another strategy used by many traders is where they move your stop to break even as soon as your position has profited by the same amount you initially risked through the same order. There are two main ways to winning when using stop losses. One, placing a stop loss at a reasonable level and two, using trailing stops to maximize your trading profit.
There are two main methods used to place stop losses. These are explained below.
Two-day low method
This is a simple strategy which is particularly useful in times of increased volatility. In this strategy, you simply place a stop-loss order approximately 10 pips below the two day low. A good example for a long position is this. Suppose EUR/USD is now trading at 1.1200, and the previous candle low was 1.1100, then you should place the stop at 1.1090.
Parabolic stop and reversal SAR
Parabolic SAR is one of the easiest technical indicators freely available in all charting software. This indicator places a small dot where the stop should be placed. In a long position, you should determine where the support is and then place a stop 20 points below it. If the trade performs well and earns 60 pips, you should now close half of the position and then move the stop up the entry point. You should then trail the stop by 60 pips behind the price.