Owen McDaniels of TradeFW outlines why risk management tools and techniques are so important in the absorbing world of online trading
Investing is an essential part of our lives, as savings alone are not sufficient to beat inflation. As investors, we typically select the appropriate investment option based on our risk tolerance and time horizon. In recent years, finance has broken new ground. Advances in technology have revolutionised the way investing is done, simplified the process of managing and controlling your portfolio, and democratised access to the financial markets in a way that we have never seen before.
Online trading is rapidly becoming one of the most popular forms of independent investing and offers global retail investors direct access to hundreds of financial instruments, including stocks, commodities, forex, crypto and more, all from the comfort of their own home, regardless of the size of their investment.
However, not only has the ease of access considerably improved, but also the quality of tools, indicators, and analysis methods to help us reach our investment potential. These include various types of risk management tools and techniques.
A question of risk
So, what makes risk management so important in trading? No matter how good a trader you are (or are about to become), there is no such thing as a 100% success rate. Any experienced trader knows that losing is sometimes just part of the game.
That said, prudent risk management is a key component for a successful trading strategy. By implementing risk management techniques, traders will be able to create opportunities from upside movement while minimising downside risk, by this opening him or herself up to non-stop opportunities that can be found on the trading platform.
Today, I’d like to take you through a few of the most common risk management tools and methods that can be used to avoid excessive risks in financial market.
Stop-loss and take-profit points
Stop-loss (S/L) and take-profit (T/P) points represent two key ways in which traders can plan ahead of their next trade. Keeping your losses small and manageable is key to being successful in your trading. A stop-loss point is the price at which a trader agrees to sell their asset and except a loss on the trade in the event a position does not pan out favourably. Stop-loss points are designed to take emotions like fear and greed out of the equation and limit losses before they escalate.
On the other hand, a take-profit point is the price at which a trader chooses to sell an asset when profit reaches a certain predefined level. For example, if a stock is approaching a key resistance level following a substantial upward move, the trader may want to sell before a period of consolidation takes place by locking in this profit..
Negative Balance Protection
Leveraged trading creates the possibility for negative balance to occur due to “owing” more than the amount of funds that are available in the trader’s balance. Negative Balance Protection is a precautionary measure that brokerage firms take in order to safeguard their clients by ensuring that their clients never lose more than they deposited. The large majority of reputable trading brokers, such as TradeFW, which is regulated by CySEC, offer Negative Balance Protection as a standard feature at no additional cost.
As investors, we’re all familiar with the saying “never put all your eggs in one basket”. The same goes for trading. If you put your entire balance in one instrument, you could be setting yourself up for disappointment. Diversifying your investment across industry sectors as well as geographic region will not only help you manage your risk, but will also open you up to more potential opportunities.
A hedge is an investment position that is opened in order to offset potential losses of another investment. Hedging is accomplished by taking an additional market position that is likely to rise in price if your existing market position declines. This is typically done by using two assets historically known for having an “inverse correlation”. An example of such an inverse correlation is the relationship between the stock market and commodities such as gold.
The one-percent rule
Many traders, especially beginners, follow what’s known as the one-percent rule. This golden rule stipulates that no more than one percent of your account should be allocated to a single trade. For example, if you have $10,000 in your trading account, any given position should not exceed $100.