Trading carries inherent risks due to economic factors, natural disasters, and political instability.
All of this can impact financial markets and cause fluctuations in asset prices stocks, bonds, currencies, etc. So, managing these risks is indispensable for minimising losses and maximising returns.
Risk management involves a variety of strategies and techniques, and we’ll explore some of them today.
3 types of trading risks
All risks, regardless of their nature, have an impact on asset prices. It’s important to consider them when managing risk to plan transactions effectively.
Market risk is the potential for investments to decrease in value due to broader economic shifts or events that impact the overall market. During the dot-com bubble of the late 1990s and early 2000s, market risk was evident as stock prices for internet-related companies soared to unsustainable levels. When the bubble burst in 2000, many of these companies’ stock prices plummeted.
Credit risk is the risk that a borrower may fail to repay a loan. A good example is the subprime mortgage crisis, when many borrowers defaulted on their mortgage loans. This caused losses for lenders and investors in mortgage-backed securities.
Liquidity risk is the possibility of being unable to quickly buy or sell investments at a price that accurately reflects their actual value. During periods of market volatility, such as the COVID-19 pandemic in 2020, liquidity risk became apparent as investors faced challenges in selling certain assets quickly without having large losses.
Any of these risks can turn a trade sour, which is why every trader should practise risk management. Let’s discuss its value.
Why is trading risk management important?
Risk management is important for every trader, and there are several reasons for that. Let’s say a trader sets a rule to never risk more than 2% of their total capital on any single trade. Even if a trade goes wrong, the potential loss is limited and won’t impact their overall capital that much.
A risk-conscious trader will also have better consistency. If one of their investments experiences a downturn, others may still perform well. They will balance out the losses and maintain consistent overall returns.
There are also psychological benefits. Suppose a trader establishes clear risk-reward ratios for their trades. This way, they will avoid the temptation to make large, risky trades or impulsive decisions driven by emotions like fear.
Finally, risk management helps traders sustain their trading activities over the long term, even during market volatility.
5 strategies for risk management
All traders, from beginners to professionals, tend to follow similar strategies. Pro traders may use more complex systems, but even those can be broken down into these five simple methods.
You can practise these techniques with Octa, a global broker with comprehensive educational resources and a user-friendly trading platform. Get started with the demo account to learn new skills and become more confident and prepared for live trading.
1. Trade size
The first rule of good risk management is making trades that align with the funds you have in your account.
If you use most of your EUR 1,000 account to open a EUR 5,000 leveraged trade, you’re risking a margin closeout. But if you use only a fraction of your EUR 1,000 account for a EUR 1,500 trade with a EUR 75 margin, you have more flexibility in setting your stop loss.
2. Stop-loss orders
A stop-loss order closes your trade automatically at a preset level.
For example, if you buy a stock at $50 and set a stop loss at $45, the trade will close if the price hits $45 or lower.
This helps control risk and establish a known risk/reward ratio. Effective stop loss placement involves analysing market structures like support and resistance, moving averages, or Fibonacci levels rather than setting a fixed distance for the stop loss.
3. Limit orders
The take-profit order is the most common limit order that closes a trade for profit. If you’re buying, the order is above the current price; if you’re selling, it’s below.
Let’s say a trader wants to buy shares of stock but thinks the current price of $50 is too high. They set a limit order to buy 100 shares if the price drops below $45, which is their target price. If the stock falls to $45 or lower, the order automatically executes. This allows the trader to buy at their desired price without constantly monitoring the market.
4. Diversification
Diversification involves spreading investments across various assets. The idea is that different investments will react differently to market events, and this reduces the overall risk of the portfolio.
Keep in mind that, on the one hand, diversification lowers the chance of major losses. On the other hand, it also limits potential gains. Just like with stop losses and limit orders, it strikes a balance between caution and calculated risk.
5. Hedging
Hedging is a strategy to protect against losses by taking opposite or related positions.
- Direct hedging. Taking the opposite position in the same security. For example, if you own shares, you can short-sell the same amount.
- Indirect hedging. Taking a position in a related asset, like buying a competitor’s stock, to hedge against losses in a company’s stock.
Hedging with derivatives is common because their connection to the underlying assets is straightforward and well-established.
Psychological aspects of risk management
Emotions are a big part of risk management. The rules are easy to understand, but following them can be tough because emotions (fear, greed, frustration, overconfidence, panic, regret, etc.) come into play when real money is on the line.
Our brains are wired to react strongly in crises, which can lead to poor decisions. We tend to stick with our initial choices, lose focus on the big picture, and get influenced by group opinions. However, research shows that we can train ourselves to handle crises better. By staying calm and focused, we can make smarter decisions and manage risks more effectively in trading.
Here are a few practices that can help:
- Practise deep breathing or take short breaks to stay calm and focused.
- Set realistic expectations to avoid emotional decision-making.
- Keep a journal to track trading decisions and identify the patterns you repeat.
- Avoid overexposure to information that may trigger emotional responses (like social media).
- Discuss experiences with fellow traders for valuable insights and support.
Conclusion
Even top traders experience losses—it’s just part of trading life. What matters is keeping those losses within a manageable range.
Remember the mantra: plan the trade and trade the plan. We’ve shown you the techniques, and they’re not too hard to learn. But the real challenge is using them every single time you trade and not letting emotions take over.
The takeaway is that everyone can grasp risk management, no matter the level of expertise.
Octa is an international broker that has been providing online trading services worldwide since 2011. It offers commission-free access to financial markets and various services already utilised by clients from 180 countries with more than 42 million trading accounts. Free educational webinars, articles, and analytical tools they provide help clients reach their investment goals.
The company is involved in a comprehensive network of charitable and humanitarian initiatives, including the improvement of educational infrastructure and short-notice relief projects supporting local communities.
Octa has also won over 70 awards since its foundation, including the ‘Best Educational Broker 2023’ award from Global Forex Awards and the ‘Best Global Broker Asia 2022’ award from International Business Magazine.
