Risk management in trading – An introduction

Risk management in trading – An introduction

In this article we will cover an essential topic in day trading and trading in general which is risk management. We will explain the most important methods for managing your risk.

In trading forex and CFDs you will be confronted with profits as well as losses. This is just the reality of trading and something to consider. When you are a trader you of course want to think about all the profits you can make with trading. The smarter way to go is actually to think about all the money you could potentially loose! This means you want to minimize losses and maximize profits.

Risk management is money management. Below you will find some essential methods for managing your risk.

Always have an exit strategy

Before you enter a trade or open a position you should have already decided your exit point. Too many traders make mistakes here. Not having an exit strategy is like getting into your car when not knowing where to drive to. Keep in mind that taking a loss is relatively easy if you follow a system but taking a profit can be very difficult.

Always work with a stop loss

In short a stop loss order maximizes the loss of your trade. Make sure you place a stop loss before entering a trade. Markets are always moving and positions and prices can change quickly. You can look at a stop loss as being the point where you admit to yourself that your trade went the wrong way as anticipated. The biggest advantage of using a stop loss is that it prevents you from emotional trading since the position is closed for you. Who knows where you would otherwise cut your losses? Keep in mind that one bad trade can ruin your whole account balance or profit.

More information on how to use a stop loss in forex and CFD trading you can find in this article.

Always work with a positive risk-reward ratio

In short you have to make sure that the amount of risk you take is smaller than the potential reward. This is a real pitfall. Most beginning traders think that the amount of winning trades should be higher to the amount of losing trades to be able to make a profit. Unfortunately this is just not possible.

Professional traders however are always looking for trades that could make a profit that is bigger than the potential loss. Let’s take a closer look and say that your win/loss ratio is 50/50. In this case you would still lose money in the long run since you have to consider that trading comes at a cost. Think of broker and exchange fees and commissions, spreads and data costs. Therefore it makes sense to earn more money with winning trades and lose less money with losing trades. Keep in mind that with a positive risk-reward ratio it is possible to make a profit even when you are right only 40 percent of the time!

Always control your risk amount per trade

In short you have to make sure not to risk more than 1 or 2 percent of your trading balance per single trade. Keep in mind that only one trade with too much risk can wipe out a large part or all of your account balance.

Draw down and how long it takes to get back to the original amount.

Percent loss drawdown vs. Percent to recover

% loss of capital% of gain required
1011.11 %
2025 %
3042.85 %
4066.66 %
50100 %
60150 %
70233 %
80400 %
90900 %
100Total loss
Drawdown recovery formula - Drawdown and how long it takes to get back to the original amount.

Always stick to the rules

In short you always follow the rules, also when you think you know the market well. Be pragmatic. Be disciplined. Avoid emotional trading. Plan ahead.

Here are a couple of do’s and don’ts in forex and CFD trading to keep in mind:

  • Focus on the trade, not on the money. Money is the byproduct of a successful trade
  • Don’t go all in. Stay in the game
  • If you fail to plan you are planning to fail
  • Know the risk, accept the risk and manage the risk (2% rule)
  • You will lose money if your losses are too high and your profits are too small
  • Experienced traders control risk, inexperienced traders chase gains (Alan Farley)
  • Expect the unexpected
  • Start small
  • Only risk what you can afford to lose
  • Do not double your trade size after a losing trade
  • Accept the fact that you will make mistakes
  • Let your profits run
  • Ask questions and create a possibility to get feedback on your trades
  • Discipline is doing the right thing at the right time for the right reasons
  • Making a loss from time to time is inevitable and is a part of trading
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