The ChoosaBroker Trading Academy

11.8. Importance of Controlling Risk in Trading

Risk management is a critical but often overlooked part of being a successful trader. While it is psychologically more tempting to focus on the profits, every trader should know exactly how much he or she can afford to lose on each trade.

Risk is essentially controlled in two ways:

  • Pulling out of losing trades before the losses exceed your tolerance limit.
  • Managing the extent of leverage used.

Cutting Losses

The newcomer to trading is overly concerned about suffering losses. He doesn’t understand that losing trades are inevitable. And in his preoccupation to avoid losses, he holds on to bad trades in the “hope” that prices will eventually turn in his favour.

Any successful trading strategy will include a disciplined approach to cutting losses. Emotions run high when a trade is live. To not get swayed, a strategy is a must. Where to enter, where to take profit and where to book loss – should all be defined before initiating a trade. This will prevent emotions from playing havoc with your trading.

Managing Leverage

Most financial assets provide leverage to traders. Leverage is a double-edged sword. While it can help retail traders, with small starting capitals, to generate some serious profits, the losses can also get accentuated. One rule of thumb that most professional traders use is to never risk more than 2% of their total trading capital on any given trade, irrespective of the extent of leverage they employ. Such a rule will help you avoid those big losses, which is the number reason for traders blowing their accounts. Leverage is particularly important in regards to CFDs; check out the best CFD brokers for more information and the learning sections on CFDs for more details on leverage.

Tools to Control Risk

Traders have two main tools to control their risk – stop loss and trailing stop loss. The former is the initial risk control mechanism, while the latter helps to manage risk once a trade turns profitable.

Initial Stop Loss

A stop loss is a type of order that closes your position when the underlying asset moves against you. Unexpected events are common in markets. Placing a stop loss is the only way to protect yourself from these uncertainties. Also, very often, without any external news moving the markets, some of your positions can go against you. The stop loss intervenes in such circumstances to shield you from that big loss.

A stop loss order can be placed when you are initiating a new trade. The location of the stop loss should be such that price moving to that level would make your initial market entering premise invalid. Technical traders typically use support-resistance areas or moving averages to locate stop loss zones.

Trailing Stop Loss

Trailing stops are an advanced variation of the stop loss order. A trailing stop is set to follow price so that if your position moves favourably but then suddenly reverses, it can lock in profits and close the position. In a long trade, a trailing stop is set below the current market price, while on a short position, it is above the current market price. Traders generally set trailing stops either at a fixed percentage level or above/below some key price level so that the trade has enough room to move in your direction without the stops getting unduly triggered. Trailing stops differ from initial stop losses in that they are used to lock in profits on a successful trade, while stop losses are intended only to control the extent of losses.

Minimize Losses for Consistent Profits

Traders very rarely like to admit they are wrong. It is part of the human conditioning. Even when a loss is staring at your face, you will keep hoping that things will turn. They seldom do, and in the process, you will end up with a bigger loss.

The fact remains that even the very best of traders suffer their fair share of losing trades. But what sets them apart is that they don’t argue with the market. The market knows best. If it says you are wrong, you humbly accept it and move on to the next trade. Keeping your losses small is critical, more so if you are into short term trading, because one big loss can wipe away the hard-earned gains of many trades.

Small losses are the price you pay for staying in the game. As the old Wall Street saying goes, “Keep your losses small, and let your profits run.” That’s the only mantra to long term success.

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