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The Importance of Risk Management in Online Trading

Creating a solid trading plan is key to achieving success in the online financial markets. An effective trading plan will not only tell you when to enter a trade, but it will also include ways to minimize the risk of loss. The fact is, the financial markets can be unpredictable and even with a good trading strategy, you can still end up with a losing trade. In some cases, if you have not responsibly managed the risks, you could end up losing all of your trading capital and more. Therefore, if you want to trade assets successfully online, you will need to implement trading risk management tactics in your trading plan. Let us explore how this is done.

Position Size

One method of risk management that should be considered is position sizing. Traders should strategically choose how much to risk per trade, which is correlated to how large of a position is executed. It is recommended that the size of a single position should not be more than 1% of your total trading capital. For instance, in an account with $10,000 of capital, the margin allocated to a single position should be no more than $100. The balance of the capital acts as a buffer against losses and floating profits, while also protecting the account from a mandatory close-out by the broker. Also, each currency pair and other assets, such as stocks and commodities, have varying volatility and risk factors. Based on this, you will want to consider adjusting position sizes to fit the specific market you are trading.

Price Targeting

One way to ensure that you know when to exit a trade, which could mitigate losses, is through setting price targets. These are specified market prices which are pre-set as part of a trading strategy and they are determined by historical price data and technical analysis. Typically, there are two main types of price targets, take profit and stop-loss orders, which can be set to automatically execute on a broker’s platform. A take profit order is set at a certain point when the trade is profitable, ensuring that you make a profit but do not get too greedy to the point that the trade could turn into a losing one. A stop-loss order is set at a specific price when the trade is losing, making sure that your potential loss for a single trade is minimized.

Diversification

Another method of minimizing risk is through portfolio diversification. This is accomplished by selecting assets which are less correlated with one another. Assets are correlated when the same factors move the markets of both assets, which means they will move at the same time and in the same direction due to high correlation. If the assets move in the same direction, they are said to be positively correlated, such as the USD/JPY and USD/CHF pairs, but if they move in opposite directions, they are considered negatively correlated, such as the USD/JPY and EUR/USD pairs. Creating a diversified portfolio means choosing assets which have low correlation, therefore distributing risk and preventing a single factor from wiping out an entire account.

Reward/Risk Ratio

Calculating the reward/risk ratio of your trades is an essential risk management method. This ratio is a measurement of the most you can lose from a trade compared to the maximum amount of profit you can earn from the trade. It is standard practice for traders to make sure they have at least a 2:1 reward/risk ratio. With this ratio, in theory, you will need to win more than 50% of your trades to make a profit. With a higher reward/risk ratio, you will not have to achieve as high of a win rate, in theory. However, it is possible to have a reward/risk ratio that is unrealistic, with the take profit level being too optimistic. This can result in an eventual loss when the market fails to reach the lofty profit goal and hits the stop loss instead.

Hedging

Another technique for managing risk is hedging. This method entails opening a market position which will be your primary position. Simultaneously, you will open a second market position on the same asset but in the opposite direction. Therefore, when the primary market position loses, the hedge will earn profits and make up for any losses. Some brokers offer a ‘protect’ feature which will enable you to open an opposite-direction option at the same time you execute a trade.

Integrating Risk Management into Your Strategy

The key to successfully applying risk management as part of a trading strategy is to understand yourself. This means knowing what your trading goals are, which could be more short-term in nature or more based on long-term investment goals. Also, the most important is to understand your personal tolerance for risk. If you find yourself constantly stressing out about your portfolio, that is a clear sign that the risk you are taking is more than your risk tolerance profile. Take the time to understand the type of trader you are and, in this way, you will be able to manage your risks, increase your profits and trade with confidence.