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Risk Management Guide

Risk management is the key to successful trading. But what does managing risk actually mean? Broadly speaking there are two types of risk management we should be thinking of: the risk on any individual trade; and the financial risk to an account. Find out more.

We are often told that risk management is the key to successful trading. But what does manage risk mean and what is the best way of carrying this out?

Broadly speaking there are two types of risk management we should be thinking of: the risk on any individual trade; and the financial risk to an account.

Risk management on individual trades

Let us deal with individual trade risk first. For every trade you place, you should have in mind a point where, if the market gets there, you decide that your view was wrong and take the loss on the chin. This is basic risk management: you do not want to hold on to losing trades forever and see your loss potentially get bigger and bigger and eventually wipe out the full value of your trading account, and more.

One of the simplest forms of risk management on a trade is placing a stop-loss order. For example, you place a buy trade in a chosen market at 100 because you think the price will go to 150. You then place a stop loss at, say, 85. This would be taking steps to manage the risk. You are accepting that the trade may not work out as planned and you are going to be disciplined and take the loss on the chin if the market drops.

Professional trading involves risk management and having a strategy for getting out if things do not go to plan as a fundamental part of this.

Managing financial risk on your account

The other basic form of risk management is designed to help protect your trading account from a series of losses. Even the best approach will have a period of losing trades.

When many of us start trading, we trade far too big relative to the size of our account. Let’s say for example that someone has £1000 in a trading account and risks losing £500 on any one trade. If their stop loss gets hit, that £500 would be the loss realized. You do not need to be a maths professor to figure out that this approach to risk management is not really managing risk effectively. A couple of losing trades and bang – the account balance is down to zero.

Most sensible approaches to financial risk management when trading recommend risking just 1% to 3% of your trading account value on anyone trading idea. This doesn’t mean setting your stop loss only 3% away, but it does mean that if a trade goes wrong and you are using the 3% approach, then only 3% of your trading account should be lost. That said, larger losses may occur where the price gaps through your stop loss level, for example due to a major news event.

Let's take the example above, buying at 100 with a stop loss at 85. Let’s assume our trader has £10,000 in an account and the risk management approach chosen is only to lose 3%. It means that if the trade gets stopped at your stop loss level of 85, only £300 should be lost.

Source: CMC Markets UK

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