How to Eliminate Risk in Trading
Eliminating risk in trading is a large challenge for traders of all skill as well as a major reason for the majority of failures when trading. Risk could even be blamed for the reason of the most recent global financial crisis, as many bankers were trading with such large leverage.
Many have the opinion that it is not possible to eliminate risk in trading, and this is true to some extent. What you do is to manage risk. At the basic level, trading can be summed up in two words — risk and reward. If there is no risk, there will never be a reward. So, take your mind away from the idea of trading without risk.
While it’s not possible to eliminate risk from trading, your primary job as a trader is that of a risk manager. Some traders don’t take risk management seriously, but to succeed in the game of trading, you must learn how to practice low-risk trading at all times. Risk management helps you to cut short your losses to protect your trading account from catastrophe.
There are many ways to manage and minimize risk in trading, and here are some of them:
Table of Contents
The importance of using an honest broker cannot be overemphasized. No matter how good your trading strategy is and how robust your risk management techniques are, if your broker is dishonest, you will never make one cent from your trading, and the money in your trading account is as good as lost.
As a matter of fact, check the broker’s trust rating. Is the firm authorized and regulated by any of the tier-1 financial regulators, such as the CFTC, FCA, ASIC, and IIROC? How does it handle clients’ funds and are there measures to protect against negative account balance?
The worst thing that can happen to you as a trader is to have a dealing desk broker who takes the other side of your trades — there will definitely be a conflict of interest. Be sure that the broker offers ECN accounts and that your account is ECN. If you would like to find the right broker for you, why not check out our broker reviews, where we fairly weigh up the pros and cons of over 30 brokers.
Trading is a very tough and emotionally draining task, and there are no guaranteed returns for all the hard work. Returns are highly unpredictable — you will never make profits from month to month. It is better you know all these now and be realistic with your expectations.
The right way to go is to understand the nature of trading and set the right goals. In the words of Mark Douglas: anything can happen, every moment in the market is unique, and there is a random distribution between wins and losses.
So, your goals should not be outcome-oriented. Instead, set execution-oriented goals. That is, to properly execute your trade anytime your trade setup appears in the market, without fear, hesitation, or pressure. To ensure low-risk trading, you must have a trading plan and follow it to the letter.
You must predefine the risk of every trade. What this means is that you have to know what you are willing to risk before placing a trade in the market. And make sure you don’t go beyond your risk tolerance. This will make it easier for you to accept a loss if it occurs.
There are different ways to define your risk exposure. One way is to know the number of pips your trade setup requires. But the ultimate thing is your account risk. How much of your account capital do you risk in a trade? It is advisable not to risk more than 1% of trading capital in each trade. You can figure out your lot size once your account risk and the number of pips to risk.
By adhering to this, it becomes easier to take a loss without losing your emotional capital, and your account will be safe from blowing up.
After defining your risk, the easiest way to make sure that you maintain that predefined risk when you place a trade is by using a hard stop loss, instead of a mental stop loss, in every trade. It saves you the emotional battle of thinking that price may reverse after you close the trade.
A hard stop loss is automatically executed once the price reaches the level where it is. It doesn’t require you to do anything else once it has been placed, unlike the mental stop loss which requires you to manually exit the trade.
Using a hard profit target is good too. Even though it doesn’t directly help you to manage risk, it helps you to maintain a reasonable risk/reward ratio and protects you from greed and hope — two dangerous emotions for traders. We believe that emotions and psychology play a vital role in trading, to learn more, click here.
It is very important that you do not use excessive leverage so that you don’t blow your trading account. Trading is a game of odds, and there’s no guarantee that the next trade or even the next three trades will be a winner.
So, why use excessive leverage that will burn your account fast if you have a streak of losses? The first rule in this game is to preserve your capital and the second rule is not to forget the first rule. If you have your trading capital, you will get the opportunity to win in the future.
Controlling your leverage comes down to the size of your positions. How many lots do you trade at a time? How does it affect your account risk? Using bigger leverage and maintaining a 1% account risk means using a tighter stop loss, which would increase your chances of losing.
It is very important to guard against overtrading because you may get overconfident and make a costly mistake that can lead to a catastrophic loss.
When you have a series of wins, take a break from trading and go do something else to clear your head. This will help you avoid getting overconfident and taking trades that don’t meet your criteria. If you trade out of excitement or boredom, you are very likely to give back all your profit plus more to the market.
Controlling your emotions is one of the toughest tasks in trading, but you have to do it if you desire to get the most out of your trading — remember, you don’t trade for the fun of it but to make money.
While volatility is good and helps you profit from huge price movements, it can also decimate your trading account if things go wrong. If you are new to trading, it is best to avoid extremely volatile conditions such as during high impact news.
Prices can spike wildly during these conditions that using a hard stop loss may not be helpful in some cases because of huge slippages and the possibility of price gaps, which can render the hard stop loss useless.
It is best to take a short break when some of the high impact news are being released. The U.S. Nonfarm Payroll report and central bank interest rate reports are some of the high-impact events you should avoid.
We have created a very helpful article in trading one of the most volatile market times; the FOMC Meetings. If you would like to learn how to trade at the time of these meetings, please click here.
It is not enough to set a limit on the amount to risk on each trade if you trade different currency pairs at the same time. If you use the 1% rule for each trade but have three trades at the same time, your risk exposure is at that point is 3%.
While trading different currency pairs at the same time is not bad, make sure the pairs are not correlated. Some currency pairs (EUR/USD and GBP/USD, for example) can correlate by as much as 80%, so trading them at the same time will only multiply your risk.
Trading currency pairs that are not correlated may be a form of diversification and can help you to lower risk. Some traders even use negatively nerve-wracking pairs to hedge their position.
Trading is a tough job — emotions can run high when things are moving our way, let alone when things are not moving as we want. A series of losses can make you abandon your trading plan and start trading haphazardly, which will even lead to more losses.
So, to maintain low-risk trading, you must have a maximum number and dollar amount of daily (if you are a day trader or scalper), weekly, and monthly losses beyond which you suspend trading for that day, week, or month.
After a series of losses or a huge single loss, it is advisable to avoid trading and do something that will help you clear your mind and regain your emotional capital. When you are coming back to the market, start with demo-trading to build your confidence.
Many of the best traders will walk away from the screen once they have lost or achieved a certain amount of points in one trading day. This is a very disciplined practice and can keep your account at a very safe, stable growth-rate.
Following on from the final point above, trading is a serious business that requires personal discipline. You need to create a trading plan and stick to it. Define what gives you an edge in the market and make a checklist for the criteria a trade setup must meet before you place a trade. Do the same for your exit strategy.
Don’t ever think of changing your trading plan until you have reached a sample size of at least 20 trades. Then, review the plan to see if it’s doing fine or needs some adjustments.
Being a disciplined trader helps you avoid bad trading habits, such as over-trading, revenge trading, and emotional trading.
Final Words
It is not possible to completely eliminate risk from trading since there can be no reward without risk, but applying the tips discussed here will help you maintain low-risk trading. Without proper risk management, it’s impossible to succeed as a trader.
This does not constitute investment advice or personal recommendations as your specific financial circumstances have not been considered. No warranty is given in regards to the accuracy and completeness of information. Past performance is not an indicator of future results