How to manage risk in trading?

Do you want to master trading risk management ? You’ve come to the right place ! Trading is not an exact science. Assets are always in motion. As a result, your decisions may not result in a gain. The risk of losing your trades is not something you can avoid.

On the contrary, this risk is inherent in the very notion of trading. To ensure that this does not have a negative impact on your profitability, it is important to learn how to manage this risk and even use it to your advantage.

In this guide, we will introduce you to all the money management strategies you can apply to manage risk. In this way, you will be able to minimise losses on your investments.

We’ll start right away with the definition of the concept of risk management

What is risk management in trading ?

Risk management in trading is the set of methods to be implemented to alleviate the negative impact that an investment in the stock market can have. This concept takes into account all the details that can generate a loss in trading. It is a kind of foundation to lay before even starting to trade. Here, investors identify, measure and analyse the risk before making the right choice.

What are the different risks in trading ?

The different risks in trading are :

Interest rate risk
Foreign exchange risk
Lack of liquidity
Leverage risk

Let’s look at these risks in more detail :

Interest rate risk : When you invest in the stock market, it is likely that interest rates will rise drastically in a short period of time. This will have a negative impact on your profitability.
Exchange rate risk : This negative eventuality occurs when the value of a currency changes at the wrong time. This risk will really impact you on the Forex market (all currency pairs).
Lack of liquidity : For a time, you may not be able to buy or sell an asset on the stock market when its price is moving against you. This is due to a lack of liquidity, and yes, in this case you may lose money !
Leverage risk : The margin offered by a broker to increase the value of your positions can work against you. This is to the extent that your positions generate a loss. You will therefore lose more money than you expected, and this can cause your balance to turn negative. This means that you owe the broker money !

So these are the dangers that are inherent in trading. Now let’s look at how to minimise their impact through risk management in trading.

What are the different risk management strategies in trading ?

The different risk management strategies in trading are :

Controlling the market
Establishing a good trading plan
Controlling leverage
The study of the risk/reward ratio
Use of stop loss and take profit limits
Follow the news

Let’s now look at these strategies in more depth.

Controlling the market

The very first strategy to implement to manage risk in trading is market mastery. You need to have a thorough knowledge of the market you are investing in to be able to minimise the risk of losses. This means understanding all the elements that can influence the price of the asset you are investing in. This allows you to assess the risk involved.

Setting up a good trading plan

Secondly, you need to plan a good trading plan. This planning is done around three key questions which are: What to invest in, when, and how much ? Answering these different questions allows you to establish a fixed guideline. This way, instead of investing randomly, you are more disciplined and orderly in your trades. And this discipline limits the risk of loss

Controlling leverage

Leverage is something you need to understand and master for good risk management in the stock market. First of all, what is it? Leverage is a loan granted by the broker to increase the value of your positions. It will therefore be of great use to you. As we said above, it can also cause your loss. So, you should take a leverage proportional to your initial investment.

The risk/reward study

As we have been saying since the beginning of this content, every investment in the stock market is subject to risk. In other words, it is inevitable. So one way to manage this factor is to gauge whether the investment you want is worth the risk. To be sure, you need to do a risk/reward study.

Use of Stop Loss and Take Profit limits

You can also do money management by limiting your positions with the Stop Loss and Take Profit settings. These trade limits will place your positions in a sort of range. When one of the limits of this range is reached, your positions will automatically close. This allows you to avoid the risk of loss that could occur if you kept the positions active 🙂

Following the news

The final risk management measure in the stock market is none other than following the news. As you know, each stock market asset belongs to a specific sector of the economy. This means that you have a constant flow of news about the different sectors to which each asset belongs. You only need to be on the front page of this information to know which assets have a high downside risk and which are the most promising.

So here are the different strategies to apply to conduct good risk management in the stock market !

Risk management in the stock market : the practical FAQ !

Now that you know the different strategies in stock market risk management, you need to learn how to use them. So, in this practical part, you will discover how to manage risk in trading through the return/return ratio, and the Stop Loss Take Profit limits. Before that, find out the importance of Money Management !

Why is risk management important ?

Risk management is important because it allows you to limit your losses. How does this make sense? It makes sense though. When you know how to do money management, you can spot assets that are more likely to go under. All you have to do is avoid them, and only invest in the most profitable stocks. This is why risk management in the stock market is so important 🙂

Note also that doing Money Management makes your job easier. This is because this concept allows you to sort through the thousands of assets available on the stock market. You end up with a precise number of priority assets to invest in. So, no need to analyse the market for several hours if you are conducting good risk management in trading !

How to do money management through the Risk/Return study ?

To do Money Management through the Risk/Return study you need to make sure that the total sum of potential gains can offset any losses. So, if you judge that you have more to lose by investing in an asset, you should simply abandon that position. The only way to be sure is to determine the risk/reward ratio 🙂

Here is an example to help you understand how to calculate this value.

Suppose you are investing in forex, more precisely in the USD/GBP pair when the price is at 2500 points. You decide to place your stop loss at 2450 points and then set your take profit at 2700 points. This means that you risk losing 50 points and gaining 200 points !

To establish a ratio, this will be 200/50, which gives us 4. You can also represent this ratio as 1:4. This means that you cannot afford to invest at a loss in this asset more than 3 times. Otherwise, your total losses will outweigh your gains !

So that’s how to use the risk/reward factor to make an objective money management decision 🙂

How to use Stop Loss and Take Profit limits ?

To use Stop Loss and Take Profit limits, you simply set a maximum loss and gain threshold. In fact, the Stop Loss represents the lowest price level you can accept in relation to your money management.

While the Take Profit represents the highest price level you can allow. You can manage risk in trading with these two limits. You need to set them at a reasonable level according to your strategy !

Here is an example to help you understand. Imagine that you are trading a low volatility market such as stocks. For example, you buy Netflix shares when the price is €600. Your goal is to earn €400 on this stock. So you set your take profit at €1000. However, you do not want to lose more than €100 on this stock.

So you set your Stop Loss at €500. So when the Netflix share price reaches a value of €1000 or €500 your position will close automatically. If you have made a gain, then you avoid the likely market reversals. Likewise, if you have lost money, this allows you to limit the damage, as things can get worse if you let positions run !

What are the benefits of money management in trading ?

The benefits of Money Management in trading are :

A limitation of losses
More discipline when investing
Ease of investment

Let’s take a closer look at what you can gain by using money management in trading :

Loss control : As we said before, doing money management allows you to reduce your losing trades. In this sense, you have an overview of the risk involved in each investment.
More discipline in your investments : Money Management allows you to order your investments through the establishment of a solid trading plan.
Ease of investment : Risk management in the stock market allows you to sort assets according to their susceptibility to loss. As a result, you can easily choose which assets to invest in for profit.