Effective Risk Management Strategies in Day Trading

Effective Risk Management Strategies in Day Trading

The global financial environment has achieved massive growth in the last decade. Today, people all over the world are able to participate in the financial market which in the past was a reserve of the large banks and hedge funds. The introduction of the high frequency trading (HFT) has democratized the financial market and as a result, many careers have been made (or destroyed.

While a number of people have achieved unparalleled success as traders, most people have lost significant amount of their investments. To achieve their success, the former group has also experienced losses. Therefore, risk management is a very important aspect of trading that no trader can achieve success without.

Risk Management is the concept of forecasting and evaluating financial risks, and then identifying the key mitigation procedures to reduce the impact. In normal businesses, traders anticipate the demand of their products and the supply. They then balance the two to serve the customers better. In forex trading, a trader must always use risk management strategies to ensure that they don’t put their accounts at risk.

Risk-Reward Ratio

When entering or exiting any trade, a trader needs to consider the amount of risks in it and weigh it against the reward. If the risk of entering a trade is very high, then there is no importance of entering it in the first place. On the other hand, if the risk of entering a trade is low, then it would make a lot of sense for a conservative trader to enter it. The challenge is on how to balance the two because the higher the risk, the higher the reward. As a trader, the key foundation to achieving success is to try to minimize the amount of exposure in any trade that you make. The recommended risk-reward ratio for a day trader is 1:2. This will prevent you from making trades that will expose your entire account to risk.

Scenario analysis

Before entering any trade, it is very important to conduct a scenario analysis for the assets or instruments you want to trade with. In this, fundamental and technical analysis are very important. For instance, if you are considering a USD dominated trade, you need to be aware of the existing economic environment. If there is any economic data being released, you need to allocate your trading with this in mind. Technical analysis will help you identify a ranging or a trending market thus helping you to make good business decisions.

Stop loss orders

As a trader, a stop loss is a very important tool to manage risk. It should be applied in all trades you enter. The essence of a stop loss is to protect your account from huge and unsustainable losses. In January this year, the Swiss National Bank (SNB) removed their currency peg from the Euro, days after a senior official assured traders that this would not happen. As a result, the volatility in the market increased significantly and many traders made huge losses. For traders without a stop loss, the losses were huge. In fact, trading companies such as FXCM went bankrupt. Traders with stop losses lost money but at a less scale.

The challenging part for new traders is on where to put a stop loss order to maximize any trade. A number of strategies have been suggested: the two-day low method and the parabolic stop and reversal (SAR) strategy. In the two-day low strategy, a trader is advised to put a stop loss approximately 10 pips below the two-day low location. It has been assumed that if the two-day and the ten-year lows are passed, a downward trend can be experienced.

The parabolic stop and reversal (SAR) is an indicator many traders use to identify the stop loss position. The indicator indicates a small dot at the position where the stop loss should be placed. A good example of this is: enter a long position and establish the support and place a stop loss 20 pips below it. Assuming that the stop loss is placed 60 pips from the entry point, if you profit 60 pips, close the position and then move up the entry point. While doing this, use a trail stop 60 pips below the moving market price. If the SAR goes up above the entry point, you can move the SAR to the stop level. By doing this, you will be experiencing sweet returns while mitigating the amount of risk exposure.

Other stop loss strategies are: using the moving average, using the support and resistance technique, and using the percentage method. The secret for any trader is to identify and master a good stop loss technique, back testing, and applying it in every trade he enters. Without a stop loss, chances of making losing all the invested capital are very high.