In trading, risk is the potential that your return from a trade may 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.
There are three main types of risk to be aware of:
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 will drive prices on the assets you trade. If you’re buying stocks, for example, then you should learn the effect that interest rates, forex prices and more might have on the companies you are investing in.
Some might 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.
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.
Say that you own shares in XYZ & Co., a relatively unknown firm. The trade isn’t delivering the returns you expected, so you want to exit the market – but you can’t find anyone who wants to purchase your stock. You may have to sell your shares for a loss to get them off your hands.
Liquidity risk is less of an issue when trading CFDs or forex with a market maker such as FOREX.com. You never own the assets in your account, so you don’t need to find a counterparty for each position.
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 market crash. Here, stocks and indices around the world tumble, with subsequent impacts on other assets. Unlike market risk, the problems are widespread and systemic.
Systemic risk can be tricky to mitigate against, but one common method is diversification. Spreading your trades across multiple asset classes and economies can help protect you if a crash arises. However, you’ll need to ensure that you research each market properly.
The key to controlling each type of risk you’ll encounter is to develop a risk management plan. A comprehensive plan will cover your exit strategy, position sizing and how you pick opportunities.
Before you enter into 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.
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 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. But, however much you are trading with, you can go a long way to avoiding large losses by paying attention to the sizing of your positions.
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 into 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 cover creating a trading plan in more detail in the Techniques of successful traders course.
