Risk Management Rules
Before we specify the basic risk management rules of trading, we should define what we mean by risk in the context of the financial markets. Risk is the potential of a bad outcome, including:
- Losing money
- Underperforming, or failing to achieve your investment and/or trading goals.
Consequently, risk management is comprised of the controls, or rules, that are put in place to mitigate the above risks. There are three main rules that make up Risk Management. The first is the use of Stop Loss. When entering the market, a trader should know what the potential risks are in advance. Traders should know when to exit a losing market which means they will know in advance how much capital they are willing to risk.
The second is Position Sizing, or how big your order is going to be. Will it be 1 lot or 0.01 lots? An important parameter for position sizing is figuring out what your risk per trade is going to be, 1%, 2% or higher? Once you’ve done that, you can specify the number of pips at risk (that is, the difference in pips between the entry price and the Stop Loss). Now you calculate your position size like so:
Trading capital = 10,000
Risk per trade = 2% (in this case, 200)
Pips at risk = 30 pips, or 0.0030 pips.
Position Size = Risk per Trade/Pips at risk = 200/0.0030 = 66667
The third rule of Risk Management is following a risk-to-reward ratio. This means that any potential profits are directly related to how much you’re willing to risk. If you follow a 1-to-3 risk-to-reward ratio, then a Stop Loss of 30 pips implies a profit of 90 pips. Similarly, when following a 1-to-2 risk-to-reward ratio, a 30 pips risk implies a 60 pip profit.
That concludes our Trading Basics series of videos – we will be diving into Technical Analysis basics in the next series, so get ready!
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Risk Warning: There is a high level of risk involved with trading leveraged products such as forex and CFDs. You should not risk more than you can afford to lose, it is possible that you may lose more than your initial investment. You should not trade unless you fully understand the true extent of your exposure to the risk of loss. When trading, you must always take into consideration your level of experience. If the risks involved seem unclear to you, please seek independent financial advice.