Five risk management rules traders should not forget
Risk management is one of the most important aspects of trading. Traders always want to get the most out of each trade while keeping risks at a minimum. Risk management strategies can help adjust your trading results and reduce losses. Its rules are pretty simple, yet they save plenty of money. Here are five tips that we encourage you to consider:
Always use a stop-loss
A stop-loss is an order that automatically exits a trade when it reaches a specific price. This is a vital tool in risk management as it helps you limit your losses. You can trade without stop-loss and track your position continuously with a manual close at the end. Such an approach may work out for some time, but eventually, you will end up distracted by something, not noticing your position dipped in a significant unexpected loss. A stop-loss helps to worry less and plan your trading results.
Assume you recently purchased Microsoft (MSFT) at $280 per share. You place a stop-loss order for $278 immediately after buying the stock. If the stock price falls below $278, your shares will be sold at the current market price.
This way, your maximum risk in this trade is 0.71%. The stock might have decreased even lower without a stop-loss and cost you more losses.
Place a take-profit
A take-profit is the opposite of a stop-loss. While a stop-loss limits possible losses, a take-profit helps to maintain your profit goals. This order closes your position when it reaches a certain positive level. The disadvantage of using a T/P is that it doesn't allow your profit to run further.
On the other hand, a supposed positive trend may reverse at a point where you could have already exited with gains. That may cause you to miss out on profit, so using T/P is better than neglecting it. Another advantage of T/P is that it allows following your strategy with a certain risk/reward ratio.
Manage your risk/reward ratio
The risk/reward ratio is the amount of money you’re willing to risk for a potential profit. For example, if you’re ready to risk $100 for a potential $500 gain, your risk/reward ratio is 1:5. As a general rule for safe trading, your risk/reward ratio should be 1:3 or less.
To calculate the risk/reward ratio, determine the risk and the reward. The trader decides both of these levels.
The total potential loss established by a stop-loss order is a risk. It is the difference between the trade's entry point and the stop-loss order.
A profit target determines the total potential profit, which is the reward. This is the time when a position is closed. The total amount you could gain from the trade is the reward — the difference between the profit goal and the entry point.
The risk/reward ratio represents the relationship between these two numbers: risk divided by reward.
For example, if you buy an asset at an entry point of $100, then place a stop-loss at $90 and a profit target at $120, your risk/reward ratio is 1:2. Such a number is considered a safe risk/reward ratio.
Don’t over-leverage
Leverage is using borrowed money to trade. While it can help you make more significant profits, it can also amplify your losses. That’s why it’s important to not over-leverage and always to use stop-losses.
For example, a trader with $1,000 on their account can trade on the financial market with $50,000 using the leverage of 1:50 or $100,000 using the leverage of 1:100. Simply put, this trader risks losing $1,000 of their own money, but if successful, will earn $100,000 if the position is opened at 100% margin and leverage of 1:100.
As seen above, leverage can cause you to lose your deposit. When you choose what leverage to apply in your trading, calculate your risks in case of a market pullback and place a stop-loss accordingly.
Diversify your portfolio
Portfolio diversification entails not putting "all of your eggs in one basket" but selecting less-correlated assets.
If two investments are affected by the same factors, they move simultaneously and have a high correlation; otherwise, they do not move together and thus do not correlate. When prices move in the same direction, there is a positive correlation; when prices move in the opposite direction, there is a negative correlation.
A non-diversified portfolio can slump spontaneously in case of a general market decrease. That’s why we recommend opening positions that have minimal correlation with each other.
On the other hand, if your positions have a strictly negative correlation, you will not get any significant results — negatively correlated assets cancel each other out.
Follow these rules and trade successfully with Grand Capital! Catch up with the next articles in our Telegram channel.
