Risk management: The most important factor to profitability

Trading concepts

Risk management

Losses are inevitable in trading and no trader not even the most successful traders can make 100% winning trades. That is why risk management is paramount to keep manage risks carefully. 

  • Trading is a very risky game that requires you to be disciplined in each aspect.
  • If you want to remain in the game for a very long period of time, you need your capital intact.
  • Traders often neglect money management and risk management.
  • Only after incurring huge losses and facing frustrations, traders turn to money and risk management. You can cut that learning curve short and avoid all the inevitable consequences by only turning to risk management.
  • There are multiple risk management techniques such as the 1-percent rule etc. that you can choose to keep your losses minimum, keep your capital intact, and remain in the game for the long term. 

Risk management trading techniques involve placing strategies to tackle adverse trading conditions. When you limit your trading positions, your overall remains minimum even if an adverse market move or series of losses do happen. It also saves your trading funds so that you can recover incurred losses through profitable trades in the near future. 

Risk management trading works on a simple principle. It measures the extent of your potential losses in comparison to profit potential on each new trade. Traders who don’t exercise proper risk management are prone to making huge losses for too long. 

Why risk management is must in trading? 

Professional traders are well aware of the importance of risk handling in trading. They know that even the tried and tested strategies can leave them vulnerable to risks because of:

  • Series of consecutive losses
  • Occasional huge losses as a result of major events such as news event
  • Market conditions are ever-changing and you cannot be 100% sure that a strategy that was successful in the past will continue to be successful in the future

Therefore, risk management is a must in trading. Without proper risk handling techniques, events like the above lead you to:

  • Loss of a major portion of your capital
  • Incur losses that cannot be recovered given your overall financial position 
  • The forced exit of a trading position at the wrong time because of lack of liquid funds to cover margin
  • An extended period of time just to recover incurred losses and restore the level of your trading funds

What are the most impactful risk management techniques? 

Risk management must be an indispensable part of your overall trading strategy. Without it, you cannot even expect to protect your capital. If you cannot protect your trading capital, you will not be able to take profits and remain in the game over the long run. 

There are various different techniques that prove instrumental in risk management. The following are the most common techniques you can employ to manage your risk.

1. Risk/reward ratio 

Measuring the risk/reward ratio is one of the best risk management techniques. Once you identify an entry signal, decide your stop-loss level first and then profit order. Measure the risk/reward ratio after identifying reasonable price levels for your trade. Just ignore the trade if the risk/reward ratio doesn’t match your requirements. Moreover, it isn’t a good idea to enlarge the take profit order or shorten your stop-loss level for a higher risk/reward ratio. Remember that profit is always uncertain. The risk is the only factor that you can control. Thus, manipulated risk/reward ratio is detrimental to your trade success. 

2. Position sizing

Dynamic position sizing is another risk management technique that professional traders employ. Trading is a game that relies heavily on chance. You might have observed that different trade setups and strategies give different outcomes because of different win rates and risk/reward ratios. That implies that you need to vary your position size on each setup and strategy. If the trade setup has a low win rate, reduce the size of your position and vice versa. 

3. Diversification

Diversification is the most basic risk handling technique. If you rely on a single instrument in order to make profits, you expose yourself to excessive risk. Conversely, when you carefully diversify your portfolio, you protect yourself from big swings in a single instrument. 

4. Stop-losses

The use of stop-loss to protect your trades from sudden changes in the market is an old but effective risk management technique. It is an extremely useful technique that helps you avoid total destruction when prices turn against you. Stop-losses are calculated in advance to find out the maximum loss you are willing to incur on a single trade if prices move against you. It helps you avoid losing more money. That means stop-losses are a good shield for traders to protect their capital in a rapidly changing market.

5. One-percent risk rule

1-percent risk rule is another risk management technique that pros follow. According to the 1% risk rule, traders should never risk more than 1% of their capital in a single trade. When you risk less, your losses are also less than you can afford. This risk management technique suits all those traders who have low trade capital. Traders with high trading capital often risk 2% or higher because they can afford it. Thus, the 1% rule is a good technique for keeping your losses under control. If you don’t follow the 1-percent risk rule, it means you are exposing yourself to incurring big losses and substantial loss of capital.

Final thoughts

Trading is a very risky game that requires you to be disciplined in each aspect. Risk management is a key aspect of trading and it demands utmost discipline. If you want to remain in the game for a very long period of time, you need your capital intact. If you don’t pay attention to risk management, you incur losses and your capital begins to evaporate. 

Unfortunately, traders often neglect money management and risk management. Although these are crucial aspects but never get enough attention. Only after incurring huge losses and facing frustrations, traders turn to money and risk management. You can cut that learning curve short and avoid all the inevitable consequences by only turning to risk management. There are multiple techniques such as the 1-percent rule etc. that you can choose to keep your losses minimum, keep your capital intact, and remain in the game for the long term. 

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