The financial market is a risky industry to be involved in. In it, many people have seen their lives’ wealth disappear in thin air. There are many examples for this.
For example, Bernie Madoff lost more than $65 billion in his pyramid scheme which he started with good intentions. Bill Ackman lost more than $5 billion when his bet on Valeant Pharmaceuticals and his short on Herbalife went south.
Some years ago, Andy Hall, commonly known as oil ‘god’ shut down his fund after weak performance. He was followed closely by Anthony Ward who was among the best known cocoa trader.
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Contents
Why risk management is important
Risk management is an important aspect in day trading. It is defined as the process of reducing your risks in the market while simultaneously maximizing your returns. The goal is to ensure that you are not extremely exposing your account to risks.
For example, when you open a trade and protect it with a stop-loss and take-profit, you have simply mitigated the risk of losing more money than you are willing to lose. All successful traders always have a risk management strategy.
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Therefore, how do you minimize your risks and avoid being in this situation?
Basic risk management strategies
Position Sizing
This refers to the size of trades that you open. In the contemporary market, if a stock is trading at $10 and you have $10000.
If you decide to spend all your money on the stock, you will have 1000 shares. If it goes to zero, you will lose your entire $10,000. On the other hand you decide to invest just $1000 on the stock and it goes south, you will lose $1000.
Similarly, in the financial market, when you open a large size, it exposes you to more risks. If it goes well, you will make more money. Therefore, it is recommended that you open small trades.
Right amount of leverage
Leverage refers to the ability of borrowing money to invest in something. It is known as using other peoples’ money.
Most brokers offer leverage to their customers. This leverage exposes them to more profits if the trades go well. If on the other hand the trades go south, you are exposed to more losses.
A common problem among many new traders is to use the biggest amount of leverage offered. To reduce the risks, you should go for a tiny amount of leverage. Doing this will help you reduce the chances of risks.
A good example of a professional trader who failed by being extremely leveraged was Bill Huang. Huang is best-known for losing more than $20 billion in two days when his home office imploded.
Huang had used excess leverage to invest in a number of stocks. When their share prices dropped, he ended up suffering from a major margin call from his bankers.
Be educated
Another problem many traders do is that of starting to trade without taking the time to learn and be educated about it. This is a challenge because many of them assume that they can buy and sell without making mistakes.
To prevent this situation, it is recommended that you first take time to learn more about forex and the financial market (and also other assets). Doing this will help you understand how the forex market works and how to avoid the popular mistakes.
At Day Trade the World™, our team of experts is always ready to provide this education to you.
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Stop Loss
A stop loss is an important tool that allows you to stop a trade automatically when a certain pre-defined level is reached. This level is usually determined by the trader according to his risk appetite.
If you want to keep trading for a long time, it is a mistake not to use a stop loss. This is because the security you are trading can move sharply in either direction. If it does, and when you have a good stop loss, it will minimize the impact.
Better still, you can use the trailing stop loss. This is a stop loss that moves with the chart and locks in the profit.
Don’t trade around big announcements
A common risk management guideline is that you should do your best to avoid trading around big announcements. That’s because of the difficulty of predicting the data that will come out and its implication to the pair. At times, a currency can sell-off even after its country publishes strong numbers.
Therefore, if you are a beginner, we recommend that you avoid trading in these periods. Advanced traders have strategies of trading these conditions like using bracket orders.
Have realistic goals
Another reason why many forex traders fail is that they have unrealistic expectations. Many of these traders want to start trading today and then double their money within a few days. This is wrong!
Instead, you should strive to set realistic expectations. For example, you can set expectations to grow your account gradually by taking lower risks.
One way of setting realistic goals is to have a small risk reward ratio. For example, You can decide to never risk more than 3% of your account in a single trade.
Focus on correlations
Correlation is an important concept when it comes to forex trading. The idea is that currency pairs usually have some relations.
For example, if you buy the USD/RUB and EUR/RUB, you have exposed yourself to a risk because these pairs tend to move in the same direction. Therefore, mastering how correlations work can help you a great deal.
External useful resources
- 5 Ways to Control Risk When Trading Forex – FX Empire