What is risk management in trading?
Risk management in trading is a way of reducing the potential impact of certain risks but also accepting that you may not be able to eliminate them. There are rewards in trading. If an asset’s price moves in the direction you predicted, you could end up with profit. However, to unlock these potential rewards, you need to accept the risks.
Naturally, you can’t develop a risk management trading strategy without understanding what risk is. Similarly, you can’t understand why risk management is important if you don’t know what the potential pitfalls of trading are.
To put it another way, you can’t have sunshine without the threat of rain. There are always going to be risks in trading. No trade is ever guaranteed to return a profit and you can’t stop a trade from moving in a negative direction.
What you can do, however, is use risk management tools to stop a trade move too far in a negative direction. So, when it comes to risk management trading, you’re aiming to reduce the risks of buying and selling, you’re not eliminating all risks because that’s not possible.
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What makes trading risky and how to manage it?
To know why risk management is important and how to do it, you need to know the potential risks you’ll face within trading. We know what the rewards are: profits. However, there are general and specific risks. The latter relates to the risks of individual assets and markets. We’ll talk about specific risks later. Before that, here are four general risks every trader has to manage:
- No amount of education and insight can guarantee you a profit in trading. However, the more you know, the better your chances of making potentially profitable moves are. This is a variable you can control. If you don’t know enough, that’s a risk. Therefore, you need to learn more about trading to help manage risk.
- Trading style
- The way you trade matters. There are various trading styles and assets you can trade. For example, it’s said that ETFs are less volatile than forex currency pairs. That doesn’t mean you shouldn’t trade forex, or that one is better than the other. Your choices and ambitions make a difference. The assets you trade, how diversified your portfolio is, and the amount of money you put in all affect your risk to reward potential.
- Leverage allows you to put in a small amount of capital and take a bigger position by using funds borrowed from a broker. This is known as margin trading because the difference between the amount of money you commit compared to the amount the broker commits is the margin.
Leveraging up a small investment can give you a bigger position and, therefore, the potential to make larger profits. However, leverage can also increase the speed at which you lose money. So, managing leverage is also a way of managing risk.
- Profit is the reward in trading, loss is the ultimate risk. You can’t eliminate the potential of either. However, you can limit them. You can use take-profit and stop-loss limits when you trade. We’ll discuss these in the next section. Online trading platforms allow you to set parameters within which your profits and losses are contained.
Risk management tools: ways to manage your trades
The risk management tools and strategies you can utilise as an online trader at Skilling are:
A stop-loss order is a risk management tool that allows you to determine the maximum loss you’ll incur on a trade. You set the amount of loss you’re willing to accept before executing a trade on Tesla CFDs, for example. Once you’ve done this, the software will automatically close a trade if your loss limit is reached, thus limiting your loss (risk).
Correct position sizing
The amount of money you commit to a trade will increase or decrease your risk. Let’s say you’ve got £1,000 to invest. Committing £750 to a single trade is riskier than committing £10 because you stand to lose 75% of your bankroll if things go wrong, rather than 10%.
We can’t tell you what to invest in. However, diversification can be part of a risk management trading strategy. For example, you might trade tech CFDs in Microsoft and Amazon, but also take positions in companies in other industries, such as entertainment (e.g. AMC and GME).
Diversifying helps reduce risk because, if the tech sector is struggling, entertainment might be thriving, for example. Diversification is a risk management trading strategy because you’re aiming to counter the downswings with one group of assets with upswings of others.
Trading fees and costs
Online trading isn’t free. Some costs and fees need to be covered and, therefore, have to be factored in because they’ll impact your bottom line. You can click here to learn more about charges, but the main ones you need to consider are:
- Swap charges
- Currency conversion fees
- Trading hours (certain markets open/close at specific times and you may have to pay fees for holding positions overnight/during closed hours)
The risks of trading different assets
We’ve explained how risks in trading can be general and specific. Some general trading risks have already been outlined in this article, but let’s talk specifics. Here is a quick overview of the potential pitfalls associated with different assets:
- Forex: Leverage is common in forex trading and, because micromovements are so significant, currency pairs can be volatile.
- Stock: The main risk with buying shares in a company is the status of the company/industry. For example, a blue-chip company is likely to have a relatively stable share price compared to a startup.
- Indices: Although indices, such as the FTSE 100, tend to be less volatile than other assets, they are at risk due to market fluctuations. For example, if there are problems in the tech industry, the NASDAQ 100 Technology Sector Index may take a hit.
- Commodities: Supply chain issues can be a major risk to commodities. For example, if there are mining issues, gold markets could be at risk. If there are shipping issues, the price of oil can suffer.
- Soft Commodities: Environmental conditions are a prominent risk when you’re trading soft commodities. Because these assets are things such as wheat, corn and sugar, adverse weather can affect supplies, which can affect prices.
- Crypto: Bitcoin is part of an emerging, comparatively new, market. So, because the technology behind cryptocurrencies is still evolving, the markets can be extremely volatile.
Manage risk when you trade online
What is risk management in trading? As we now know, it’s the process of limiting your losses. You can’t eliminate the risk of losing money, but you can reduce the negative impact of certain variables. Once you’ve processed this concept and used the information in this guide to develop your risk management trading strategy, take some time to learn more about trading in general. Some things to consider before you enter the financial markets are:
- What is your trading style going to be?
- What hours can and should you trade?
- What is forex and how do signals work?
- What are CFDs and how do they work?
When you’re versed in the fundamentals of trading and understand risk, click here to create an account at Skilling.
Not investment advice.
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