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Managing risk

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Risk management

4.5-minute read

Risk is an essential part of day-to-day trading – without risking capital, you can’t achieve any returns. Traders today have a suite of tools to help them control risk as they manage their positions.

What is risk in trading?

Risk in trading is the potential for your return from a trade to be lower than you expected. That could be because you had to close it beneath your profit target, or it could mean losing all the capital you spent on the position.

No trader gets every decision right. So, it’s essential to develop a comprehensive plan for managing risk within your trading – especially when using leverage, which will amplify losses as well as profits.

Types of trading risk

There are three main types of trading risk to be aware of:

1. Market risk

Market risk is the possibility that your trades will earn less than expected due to adverse movements in market prices. It is the most common type of risk and the one that most traders do most work to mitigate.

One important step to controlling market risk is to understand the unique factors that drive prices on the assets you trade. If you’re buying silver, for example, then you should learn the effects that interest rates, forex prices, and more have on the metal.

Some factors may be obvious, but others can be more obscure. So even if you think you know your chosen market well, it’s always worth using stop losses and take profits.

2. Liquidity risk

Liquidity risk arises when you can’t exit a trade as quickly as you want to. This may hurt your profits or lead to a loss from the position. Forex markets are prized for their liquidity, but liquidity risk can still be experienced in times of financial crises or when trading currencies seldom used in world trading operations such as the Singapore dollar or South African rand. Often these risks occur outside of US and European trading hours when forex liquidity is lowest.

Say that you opened a position on an exotic currency pair such as USD/NOK. The Norwegian Krone isn’t rising against the dollar as you expected, so you want to exit the market. However, few people are looking to go long on USD/KON, so the bid-ask price widens, and you’re forced to sell your position at a lower price than anticipated. Liquidity risk is less of an issue when trading with a market maker such as FOREX.com, as you never own the assets in your trading account. As a result, you don’t need to find a counterparty for each position.

3. Systemic risk

The final risk you should be aware of is systemic risk. This refers to the chance that an issue with the wider financial system will hurt your bottom line.

A classic example of systemic risk is a global financial crisis. Here, bank reserves around the world may freeze and interest rates plummet, with subsequent impacts on forex. Unlike market risk, the problems are widespread and systemic with all major economies affected.

Systemic risk can be tricky to mitigate, but one common method is using stops and limits. These order types can safeguard your trades from outsized losses if a crash arises.

Developing a trading risk management plan

The key to controlling each type of trading risk you’ll encounter is to develop a trading risk management plan. A comprehensive plan will cover your exit strategy, position sizing, and how you pick opportunities.

Exit strategy

Before you enter any position, you should know exactly where your ‘point of pain’ resides: the maximum loss you want – and can afford – to risk from any single position. Consistently allowing losing trades to go beyond this point is a recipe for failure.

So, decide the maximum you can lose from any given trade and stay disciplined about exiting any market if it hits that level. A common mistake among traders is to hold on to losing trades in the hope that they will turn around. A good risk management plan will help you avoid this potential hazard.

Consider entering stops on all your trades.

Position sizing

Another habit of many pro traders involves position-sizing, which is where you decide how much capital to allocate to each opportunity ahead of time.

Before you open your first live trade, it’s a good idea to determine a proper position size according to the size of your trading account. This can help you control and quantify your risk.

Obviously, a $10,000 account may use different position sizes than one with $1,000,000. However, regardless of the amount you are trading with, you can go a long way to avoiding large losses by paying attention to the size of your positions.

Finding trades

Instead of rushing into new positions, opportunities should be weighed and considered carefully.

This means creating a detailed trading plan as part of your preparations and sticking to it. Try to avoid entering any trades randomly or haphazardly, based on the emotions of excitement, greed, or fear.

The fact that a market is rapidly moving in one direction or another may not constitute a rational reason for getting into a trade.

We’ll cover creating a trading plan in more detail in the Techniques of successful traders course.

Key trading risk management takeaways

1. Trade with the prevailing trend

Consider taking the path of least resistance and go with the flow of the current market.

2. Establish a detailed strategy for entering and exiting trades

A detailed strategy defines parameters for getting into and out of trades – so there's no ambiguity.

3. Watch your downside risk and be prepared to act decisively

Make sure that you're disciplined enough in preserving your account so that you can live to trade another day.

4. Trade with reason, not emotion

Human emotions (excitement, greed, fear) don't always lend themselves to successful trading.

5. Avoid trading right around scheduled news events

Markets can become more volatile around news events, meaning prices may move drastically within short periods.

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Test your knowledge

Question 1 of 3
You have an open long position on EUR/USD which has hit your profit target, but you are unable to close your trade because you can’t find a buyer. Is this an example of:
  • A Market risk
  • B Liquidity risk
  • C Systemic risk
Question 2 of 3
The Federal Reserve lowers interest rates, which sends the USD down and adversely affects your open short USD/JPY position. Is this an example of:
  • A Market risk
  • B Liquidity risk
  • C Systemic risk
Question 3 of 3
A political crisis engulfs the EU, causing your long EUR/USD position to fall. Is this an example of:
  • A Market risk
  • B Liquidity risk
  • C Systemic risk
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