Risk Management

Definition: Identifying potential risks before they happen, analyse them and take action to reduce the risk.


In the financial sector, pretty much everything has an element of risk. Your own bank account, despite you thinking it is the safest place for your money, there are risks holding it there. What happens if the bank collapses and cannot pay out your money?

  1. Lehman Brothers famously was the fourth largest investment bank in the United States and collapsed during the financial crisis, leaving its clients scrambling for their money.
  2. The Greek banks during their crisis were limiting how much clients could withdraw from their own account.

There are always risks associated to investing your money and understanding those risk is imperative when it comes to trading assets.

Capital at Risk

Capital at Risk - Crocodile

Every time you take a trade you are risking your capital and that is the biggest risk of trading any assets. As a trader you therefore have a responsibility to manage your risk, maintaining that any losses are controlled and managed.

Essentially the most important thing is to keep your losses consistent. If you can choose the amount you are going to loser before you lose it, then you should stick to that much every time.

Risk Reward Ratio

Before we look at risk management strategies, we must first understand what a risk reward ratio (RRR) is. This is the ratio that measures how much you could potentially profit for every dollar you have at risk.

If you were risking £100 to make £100, your RRR would be 1:1. If you were risking £100 to make £300, your RRR would be 1:3.

It is normally advisable to never go below a RRR of 1:1 however this depends on your win rate. If you are hitting 50% win rate, then 1:1 isn’t enough to make profit. However, if your RRR was 1:2 and your win rate was 50%, then you would be making profit. Let’s do the math’s quickly.

Quick Look at the Math's

If you’re risking £100 in order to make £200 and you take the exact same trade 100 times.

Thumbs up - Old lady

50 wins & 50 Losses

(50 x £-100) = £-5,000

+

(50 x £200) = £10,000

= £5,000 Profit

This one example shows how important it is to stick to your strategy and making sure your psychology is correct to make sure you are not cutting your profits short or playing with your stop loss.

If you can get a RRR that works with your strategy and you stick to it then you can see the profits to be made.

In an ideal world then every time you took a trade you would simply take the trade and leave it. Let it either hit the target or stop loss. This is where psychology comes in, people get greedy and people get scared. This is why we would urge new traders to follow a strategy on demo before going live. If you can see it working on demo then it makes it psychologically easier to do when you’re on a live account.

Risk Management Strategies

Stop Loss & Profit Orders – These are automatic orders that near enough every broker now offers. They are orders that traders can put into the market that once the price gets to that level they will automatically buy or sell the market at that price. If you use these orders every time, you can manage exactly how much you are going to lose every time.

Stop Loss and Take Profit Orders
Stop Loss and Take Profit Orders

While that sentence does not sound nice, it is very important that you get it into your head that you will lose and actually managing your losses is the foundation of making consistent profits.

Position Sizing – This is how much you put on each position. Depending on your strategy this may or may not be the same for each trade. Normally this will change for every trade you take, the reason being is because your stop loss will not always be the same distance from your entry.

Before you take a trade you should know exactly:

  • How many pips you are will to risk
  • How much money you are willing to lose (this should be consistent for every trade)

Once you know these two, only then can you calculate your position size.

Calculate Your Position

Trade Size = £ Risk / Pip Risk

Or

£ Risk = Trade Size x Pip Risk

Trade Size (% of Account at Risk) – The amount you are willing to risk is up to the trader in question. However, you should think about it as a percentage and not as a numerical value.

It is widely recommended in the industry that you should not risk more than 1% of your account on any one trade. If you have an account of £10,000, then no trade should ever lose more than £100. This way it will take 100 bad trades in a row for you to blow your account. The chances of that happening are very slim.

1% Risk
No More Than 1% Risk On Every Trade

There will always be more risk adverse traders out there but the higher your risk goes the less trades it will take to blow your account. Using the example above, if you’re willing to risk £1,000 per trade then it will only take 10 bad trades for you to blow your account.

Loss of Capital % Required to get back to breakeven
10% 11%
20% 25%
30% 43%
40% 67%
50% 100%
60% 150%
70% 233%
80% 400%
90% 900%

Trading is about the long game and not the short term wins. A more impressive portfolio is one that climbs steadily rather than erratically.

If you were a fund manager in charge of millions of other peoples money, who would you rather trust with that money? Someone who has a steady growth with small losses or someone who has huge swings, sometimes finding their balance negative?

Total Risk – Whilst it is said you shouldn’t over 1% on one trade, it is also advised that you shouldn’t risk more than 2% of your account at any one time. This way, should everything go wrong, you will only lose 2% at one time.

The 2% Rule

If you were to have 10 trades open at 1% risk each, you would have a total of 10% of your account at risk at once, and should the worst happen, you have done your months risk in a day. Absolutely far from ideal!

This does not mean that you can only have two trades on at once, it just means that you need to manage your risk to not go over 2%. You can have 4 trades on at 0.5% or 8 at 0.25%, it is up to you, but ensuring you don’t lose too much in one day is also important.

As we highlighted earlier, trading is a long game and while you should consider each trade, you should also consider your losses in terms of days, weeks and months. Typically the below percentages are the most you should lose in that time period;

Max Losses Per Timeframe

Day – 2%

Week – 6%

Month – 8%

If you start losing more than these amounts then your account is in real danger and realistically you should be going back to the drawing board and assessing what is going wrong because profitable traders do not lose more than that.

A common mistake by new traders is that they are so desperate to make back what they have lost that they end up increasing their risk to try and ‘win back their losses quicker’. Famous last words. If you find yourself saying or doing that, then take a step back and reassess. That is called chasing your losses and more often than not, the trader loses.

Diversification – This is an investment technique which limits a trader or investors portfolio exposure to one asset or asset class.

An example for an FX trader may be that they have 4 trades open and all four have GBP in the currency pair. This means that the trader is exposed to any GBP news or fluctuation and in the likelihood of an extreme move, all trades could come in at a loss at the same time.

Asset managers also adhere to diversification in the asset classes they invest in. They will not like to be overly exposed to any one asset and is why you will often see a percentage split of an investors portfolio across various asset classes.


Other Risks

Slippage – This is when you enter a market at a price above or below the expected entry. An example may be when you want to buy GBP/USD at 1.3010, but when you execute the trade you in fact have an entry at 1.3030. In this example the trader has been slipped 20 pips.

Slippage
Example of Slippage (not a real trade)

Slippage can happen in any market, it is perhaps less common in the FX market because of the liquidity however it is still fairly common when you get an extreme move that a trader will be filled at an unexpected price.

Slippage tends to occur during highly volatile moments, in the FX market you would expect to see this during interest decisions or other major announcements.

Gaps – These are when the market simply jumps and does not trade at one price. It is a common occurrence in the stock market because the market closes everyday and will often open at a different price to the close price and hence ‘gapped’ over some prices.

Gap

One of the largest risks of gaps pose is that should they not trade at a certain price, then if a trader has a stop loss and the price gaps over it then all of a sudden you have more than you originally planned to risk on a that trade in question.

How to manage gaps in the market:

  • Close trades leading up to potential highly volatile events where a gap could occur
  • Use a broker who can guarantee your stop loss despite any gaps
  • Should your stop loss be ‘gapped’, CLOSE your trade immediately. Suddenly you are running into more risk than you expected and you should cut your losses.