Most successful traders use risk management as part of their trading strategy. This is as much down to the importance of protecting gains as limiting losses. There are numerous ways in which you can protect your trades against unexpected market moves.
This article covers the basics of risk management in trading, especially when you are using forms of leveraged trading such as spread betting and contracts for difference (CFDs).
What is leveraged trading?
Leveraged (also known as margined) trading gives you a larger exposure to the market. This means that you are able to open a trade by putting down just a fraction of the full value of the trade you are looking to place. Leverage allows you to use a small amount of capital to control a larger sum of an asset.
Leverage is a great way to gain exposure to the market. Your potential for profit can go up when the market moves in your favour. It is important to remember, however, that your potential for loss can also be compounded when market prices move in the opposite direction.
Take, for example, real estate. When buying a home you may deposit a small percentage of the total value of the property you wish to buy to secure your mortgage. This is like trading on leverage. You will deposit a small amount of funds, which will allow you to have more exposure on that trade. But there are two sides to this exposure. One, you have the potential to gain much more based on the amount of leverage on your trade. Two, you have the potential to lose much more than the amount you have placed on the trade should prices move against you.
Remember to monitor the spread
What is the spread and why is it important? Your spread betting, CFD or FX trading platform will offer two prices for the instrument you wish to trade. The two prices you will see are the buy price and sell price. These dictate what the spread will be. The difference between the buy price and sell price will be the spread. Let’s say, for example, gold is currently trading at 3,368.5/3,370.5 (buy price/sell price). The spread here is 2.0.
The lower or tighter the spread, the lower your trading costs will be. So knowing how spreads work can allow you to project your trades for a profit or reasonable loss.
How do stop losses work?
There are numerous ways in which you can protect your trades against sudden market moves. These include the use of stop losses and guaranteed stop losses. Stop losses are designed to close out your trades at a pre-defined price for a loss should the market move against your trade. The idea is to stop you from racking up larger losses in adverse market conditions.
As a trader, this means that you will have calculated the amount you can afford to lose beforehand, based on the point where you have placed the stop-loss order. If the trade goes past the point where you have placed the stop, it will exit the trade and remove you from that trade at a loss. Although stop-loss orders can be a great risk management tool, they are not fool proof in comparison to guaranteed stop-loss orders (GSLOs).
Most trading platforms these days offer stop-loss orders at no extra charge. There will be an extra charge for using a GSLO, however, as these are premium (and not all providers offer these).
Difference between stop-loss orders and guaranteed stop-loss orders
The difference between a regular stop-loss order and guaranteed stop-loss order is that with a stop-loss order, there is no guarantee to close out your trade at the pre-defined price. This means that if the market price slips past your positioned stop loss due to sudden volatility, your trade could be closed at a worse price and your losses could be higher. A guaranteed stop-loss order will take you out of the trade at exactly the point you state, irrespective of market gapping or slippage.
What is a take-profit order?
A take-profit order or limit order works in the same way as a stop-loss order. The difference is that, as the name suggests, take-profit orders close your trades at a pre-defined level for a profit.
Using a reward:risk ratio
A risk:reward ratio effectively determines how much you expect to make on a trade, against how much you are willing to lose. This will be dependent on your personal circumstances and trading goals. If, for example, you have a reward:risk ratio of 1:1, it means you will need to have over a 50% profit rate to make a long-term profit. So for every losing trade, you need to have a winning trade.
A carefully planned reward:risk ratio in conjunction with stop and limit orders can help you project what your earnings or losses can be from any given trade.