Risk management is perhaps the most critical yet overlooked aspect of trading, particularly for beginners euphoric over scoring big wins early on. However, the ugly truth is 95% of rookie traders end up losing money in the long run. Without prudent risk management, even seasoned traders can hit major drawdowns jeopardizing their business.
So why do most traders fail? A huge component is lack of risk control. Amateurs enter positions impulsively without plans for limiting losses. When losses hit, they average down hoping the market will reverse. As losses mount, risk management goes out the window while they pray for a miracle turnaround. This gambling mentality destroys accounts rapidly. By managing risks properly from the start, losses can be minimized while maximizing potential profits over hundreds of trades.
Risk management separates seasoned traders from gamblers. Through techniques like understanding personal risk tolerance, setting and adhering to rules, diversification, judicious leverage use, journaling and ongoing refinement, traders can endure inevitable losses during losing spells while optimizing gains over the long haul. Make risk control priority one from day one and shift the odds dramatically in your favor. Use losses as learning opportunities rather than disasters sinking your ship. This article explores 10 best practices for managing trading risks.
Identify Your Risk Tolerance Level
Before diving into trading, it’s vital that you identify your personal risk tolerance level. This refers to the amount of risk and potential losses you are comfortable accepting. Traders have varying risk tolerance levels depending on factors like personality, financial situation, and investing goals. Are you looking to play it safe with minimal losses? Or are you more of an aggressive trader willing to accept higher risks for potential higher rewards? Knowing your risk tolerance guides what trading strategies you employ. Traders with low risk tolerance would use tighter stop losses. More risk-seeking traders may use more leverage. Define your risk tolerance first to match appropriate strategies.
Set Trading Rules and Stick to Them
One of the biggest reasons traders fail is the lack of trading rules. Effective risk management starts with setting detailed trading rules that dictate your entries, exits and define how much you are willing to lose on any given trade. Rules should align to your risk tolerance and be written down. They must address questions like: What % of my account will I risk per trade? How many consecutive losses before I stop trading? What risk-to-reward ratio will I target? With clear rules in place, it becomes easier to stay disciplined and remove emotion-based trading errors. Always stick to your trading rules without exceptions.
Diversify Your Trades and Portfolio
The old adage “don’t put all your eggs in one basket” very much applies in trading. Diversification should be part of your risk management plan. Rather than concentrating all your capital on just a handful of large positions or sectors, diversify across different assets, markets, industries and timeframes. This ensures one or two losing trades won’t cripple your account. Diversification also exposes you to varied market conditions and opportunities. You’ll smooth out portfolio performance over time by diversifying wisely. Learn more about it at the link
Use Stop-Loss Orders
One of the biggest techniques used by professional traders is stop-loss orders. A stop-loss order automatically closes out your trade position once a price decline reaches your predefined stop loss level, helping limit how much you can lose. Stop losses contain the downside risk on all trades. For long positions, place stop loss orders below recent support levels or below entry price if no significant support exists. For shorts, place stops above overhead resistance. Choose wider or tighter stop loss distances based on your risk tolerance. But always use a stop loss order on every trade.
Limit Your Position Size
Amateur traders tend to risk too much capital on single ideas. Even if you have strong conviction in a trade, risk management best practice is to limit position size so no single trade causes major damage. As a rule of thumb, risk no more than 1-5% of your account per trade. So if trading a $10,000 account, maximum risk would be $100 – $500 for any new position. This ensures many losing trades in a row won’t demolish your account, allowing you to continue trading.
Don’t Trade on Margin/Use Leverage Unwisely
Margin or leverage allows trading larger position sizes relative to account size by borrowing money from brokers. While leverage can amplify profits, it also dramatically amplifies losses if used recklessly. Even veteran professional traders blow up accounts through unrestrained leverage. It’s best suited for extremely short-term trades only. If using leverage, limit to 1:1 or 1:2 ratio relative to account size at most. Or avoid altogether until fully grasping the immense risks involved. Margin can too easily obliterate accounts through amplified losses on a single bad trade.
Keep A Trading Journal
Keeping a detailed trading journal supports ongoing improvement. The journal should log details on chart patterns, indicators, fundamentals or catalysts behind every trade entry and exit. Also record emotional state at the time of placing trades. Doing so allows reviewing past trades to analyze what worked, what didn’t and why. Identify and fix common mistakes revealed through journal review. It supports tweaking strategies, rules and risk management over time to optimize performance. Ongoing journaling leads to trading longevity.
Take Profits When You Reach Your Goal
Many traders focus entirely on entries and stop losses while ignoring profit taking rules. They may continue holding a position as it turns profitable, getting greedy hoping for even bigger gains. This is dangerous as markets can turn instantly. Define clear profit taking rules based on a reward target or chart level ahead of time in your trading plan. Then strictly adhere to taking at least some profits when your predefined target gets hit. Exiting at least partial share amounts at your target helps lock in gains in case the market reverses.
Continuously Review and Refine Your Risk Management
Risk management requires ongoing refinement rather than being a one-time exercise. Review your trading data and journal frequently. Identify areas your risk management failed or could improve. Common problems like placing stop losses too close or improper position sizing can be revealed and fixed through regular analysis. Refine rules around entries, pyramiding into winning trades, using trailing stops etc. Effective trading is a process of constant incremental improvement to risk management. What you learn can mean the difference between struggling or thriving in your trading career.
Conclusion
Managing risks separates consistently profitable traders from gamblers eventually blowing up their account in financial markets. Through techniques like knowing your tolerance, setting and following rules, diversification, judicious leverage use, journaling and refining approaches through reviews, traders can minimize losses during inevitable losing spells while optimizing gains over the long run. Make risk management priority one and the odds shift in your favor.