How do I manage risk?
No trade is without risk and there is always a chance of losing capital. You need to be aware of – and able to cope with – all possible outcomes. Here’s your essential guide to risk management strategies.
What is trading risk?
Trading risk is the danger that a trade might go against you, causing you to lose money. Some trades carry greater risk than others – this will depend on factors such as the markets you trade, the products you choose and the amount of capital you use.
Certain products offer a fixed level of risk, such as Nadex Binary Options, where it will be clear how much you stand to win or lose before you place the trade.
What is risk management?
Risk management in trading refers to the steps you take to ensure the outcomes of your trades are manageable for you financially. It is an ongoing process to protect yourself from losses that you can’t afford. Risk management is equally relevant to day traders, professional traders, and traders with retail accounts, as everyone will have their own affordability limits.
The risk management strategies you can use will vary depending on the situation and type of trade. The sign of a good risk management strategy is that it enables you to understand potential gains and losses, so you can make an informed decision about whether to place a trade.
Consider all possible outcomes
Trade strategically, not emotionally
Diversify your exposure
Use capped risk products to trade
1. Consider all possible outcomes
Markets can move fast, and while you might think a trade seems like a safe choice, it’s always possible to get caught out. Trading inherently involves risk, but the level of risk can be calculated; make sure you are comfortable with the amount of capital at stake. Fixed risk products like Nadex Binary Option contracts help you to fully understand all potential outcomes before placing a trade.
2. Trade strategically, not emotionally
One of the greatest risks to traders is letting emotions interfere with a trading strategy. When you trade based on an emotion, you are in danger of moving away from your plans and going against logic, exposing you to an elevated level of risk. If emotions are left unchecked, big wins are often followed by heavy losses; traders spurred on by a winning streak might open new positions with less consideration and make reckless decisions. It’s important that you have a good grasp of trading psychology and know how to trade effectively. Developing a trading plan and sticking to it is the best way to avoid emotional interference.
3. Diversify your exposure
Diversify your exposure as opposed to putting all your capital into one trade or market. This way, you are more likely to be protected if your chosen market moves against you, or if a particular trade doesn’t go your way.
4. Use capped risk products to trade
Capped risk products enable you to see your maximum profit and loss upfront. They are different to leveraged products, where you could lose more than your initial deposit. With binary option contracts, you will know your maximum possible risk and reward before you place your trade. You can also limit your losses by leaving a trade early or set a take-profit order – you don’t have to wait for expiration.
5. Don’t follow the herd
Your chosen levels of risk will be personal to you. Just because another trader is taking bigger risks, this doesn’t necessarily mean they will be making the right predictions – and they certainly won’t be making the right decisions for you. Know the maximum risk you’re willing to take and stick with it.
Working out the maximum risk on a trade-by-trade basis
When you’re devising a trading strategy, you will come across lots of general advice about the maximum percentage you should risk. What this is referring to is the percentage of your total capital that you can afford to place on each of your trades. Around 2% is often considered to be a sensible amount; many traders will take steps to ensure they won’t lose more than 2% of their capital. The theory behind this is that 2% is low enough to prevent major losses, without forfeiting opportunities to profit. Thinking in this way can make you a more sensible trader, but be aware that it’s not a definitive rule, more of a practical step. Here is an example of how this works:
1. Let’s say you have $1,000 of trading capital to invest. You need to work out the percentage of this capital that you can afford to place on each of your trades.
2% of your capital = $20
3% of your capital = $30
5% of your capital = $50
10% of your capital = $100
2. If you place trades using 2% of your capital, the maximum amount you could lose over five trades is $100 – only 1/10 of your capital (assuming you are trading with a product where risk is capped, like binary options). If you were risking 10% of your capital over five trades, you could lose half of your original capital.
3. This model assumes the worst-case scenario so of course, you might not have a losing streak. However, a thorough risk assessment should always show maximum possible losses because you need to understand exactly how much capital you are putting at risk.
Once you understand your worst-case scenario and how the risk per trade impacts your overall account value, you must use this information to take a disciplined approach to each and every trade. When traders fail, it’s often not because a series of trades goes against them, but because they decide to ‘double-up’ and chase the market following their losses. It’s important not to fall into this trap, and to keep each loss at a low percentage of your overall account value. By doing so, you are much less likely to hit the psychological tipping point that has doomed many aspiring traders.
Considering the risk compared to the reward
The second important technique for analyzing and understanding risk is to consider it in relation to the possible reward. For many traders, a 1:3 risk-to-reward ratio is something they feel comfortable with, offering manageable losses and good profit potential. With Nadex, it’s even easier to see a direct comparison between your maximum profit and loss as they are shown on each order ticket. Binary option contracts always add up to $100 so you can understand your risk-to-reward profile. If, for example, you choose to buy a binary option contract for $30 and your order is in-the-money at expiration, you will receive $100 for the trade. Minus the $30 capital you put in, this leaves you with a $70 profit (excluding fees). You can never lose more than you put in, so if the trade finishes out-of-the-money, you will lose your initial $30 (plus fees) and nothing more.
Keep in mind that the markets have to move more for you to achieve a bigger profit. If it is very likely that the market will achieve your strike price, or the market is already above your strike price when you enter the trade, then your profit will be smaller. You might be tempted by the prospect of more risk and bigger profits, but ensure you trade rationally and stick to your plan.
Risk management: a process as individual as your trading aspirations
Many aspects of risk management are common sense and logic, while others take a little more thought. Risk management will involve a combination of tactics and a general sense of awareness, but it will be different for each trader. Your risk management strategies and trading plan will go hand in hand.
You can develop a strategy before risking real capital by opening a Nadex demo account. This enables you to trade with $10,000 in practice funds.
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