Risk management is an essential part of trading smartly and effectively - and should form a substantial section of your trading plan.
Managing your risk well will be beneficial in the long and short term: you’re less likely to blow your account; you’re more likely to maintain a healthy mindset, and your trading journey will likely last longer as a result.
Aside from psychological elements (such as monitoring your mindset) there are plenty of practical and technical measures you can take to make sure you’re managing your risk correctly - including never moving your stop loss order during a losing trade to setting a realistic risk-reward ratio.
See our top risk management tips below!
4 Essential Risk Management Tips
1. Set a stop loss order - and never move it
The first step in managing your risk is setting a stop loss order. A stop loss - an order placed to buy or sell once an asset reaches a certain price - is a key part of trading as it will help you to minimise and manage your losses.
But make sure you’re strategic here: choose a stop-loss percentage that allows the market to fluctuate day to day while preventing as much loss as possible. For example, setting a 5% stop loss on a stock that has a history of fluctuating 10% or more in a week would not be the best idea - so make sure what you choose is realistic, both for you and the markets.
However, it’s not enough to set a stop loss - you have to stick to it! This is where the real test of risk management comes in.
If you’ve ever found yourself in a losing position and found yourself considering widening your stop loss, you’re not alone - but remember that stop losses are there for a reason!
It can be tempting, we know, to think ‘I’m already losing. May as well wait in the hope that the market turns here.’ But this is a huge mistake! Widening your stop loss will only increase the losses you make. It’s far better to take the hit as it is than let it run. Trust us.
2. Don’t risk more than 1% per trade
This is an essential part of risk management. How much of your capital you risk per trade will depend on your financial situation, but it’s generally recommended that you risk no more than 1-2% of your capital per trade.
Risking any more than 4 or 5% is considered high risk, so it’s best avoided if possible, as this can lead to severe losses.
For example, risking 2% of your capital would mean that if you had $10,000 in your trading account, you would not lose more than $200.
As with widening a stop loss, we know it can be tempting to risk more capital on a trade - especially if you’ve lost a big amount on a previous trade and think that by risking more you can win your capital back (or, equally, if you’ve won a big amount on a previous trade you might be tempted to try to make an even bigger profit).
If you find yourself in this position, it’s a good idea to check your mindset and take a step back for the day.
3. Set a 1:3 minimum risk-reward ratio
The next step: setting a realistic risk-reward ratio. Your risk-reward ratio measures the difference between the profit potential of a trade relative to its loss potential - in other words, how much you’re risking compared to how much you might earn.
For example, if the distance between your entry level and your stop-loss is 50 pips, and the distance between your entry point and your take-profit is 150 pips, then you would be using a RRR of 1:3, because you’re risking 50 pips to earn 150 pips (150/50 = 3).
So - what should your risk-reward ratio be? It’s a personal choice that will depend on your available capital and how much you are willing to risk - but generally speaking, a good ratio is usually anything greater than 1 in 3. In this case, you’d expect to win three times what you’re willing to lose.
4. Understand currency correlations
Currency correlation is the idea that currency pairs often move in similar ways - for example, moving in the same or opposite direction over a period of time.
If you have multiple positions open - and each position consists of a different currency pair - you may be exposed to risk. For example, usually, trading AUD/USD and NZD/USD is like having two identical trades open because they usually move in a similar manner.
So you can see the problem: you may be unknowingly exposing yourself to double the risk. It’s essential, then, that you understand how currency pairs move in relation to one another.
In order to avoid making this mistake: read up on currency correlation, make sure you’re aware of how many pairs you’re trading at once, and in most cases, make sure you pick one out of two setups.
Interested in joining BluFX but got some questions first? Read our blog, 5 BluFX Myths Debunked.