It seems so simple. ‘Buy’ before the price rises, ‘Sell’ before the price falls. Close the trade when it first starts to reverse. Who needs risk management? There are dozens of factors in play that make that question ridiculous and naive. So you’ve figured out how to use a few indicators, and you’re checking the economic calendar every day. These are excellent ways to improve trading performance and target greater profits, but there’s also something that protects you so when something unexpected happens, your entire equity isn’t vaporized.
What is risk management?
It’s about not biting off more than you can chew. It’s a properly balanced trading budget:
- Amount traded
- Stop Loss and Take Profit
- Strategic withdrawals
Interestingly, many traders with 3 to 6 months' experience already know the importance of these 5 risk management factors, but they often and consciously overlook them. This happens because the first few weeks of cautious trading can go well, and courage (or even greed) sets in and starts creating visions of a luxury vacation or supercar. Overextending your leverage and trading volume will zero your account faster than a Ferrari can hit 100.
This false sense of trading performance also occurs with traders who spend too much time on the demo account. Newbies start trading on the demo, and the moment they see profits, they turn up the volume. Continued success at the higher trading volumes then inspires intrepid increases in leverage and investment. This prompts the new trader to start investing thousands. Try to move to a real account before that happens. In spite of the danger of losing perspective, do not skip risk-free demo trading. The trick is to stay realistic in your actual financial goals or dial back your trades when you switch to pursuing real profits.
More than just conservative trading
It’s not about losing less frequently. That’s not what risk management is about. It’s about losing less on the negative trades that show up throughout the week. Let’s look at the main tools used by savvy traders who use risk management.
Lot size management
Your typical lot size should depend on your budget or account balance, not on your gut feeling or what that guy on YouTube did. If you’re new to trading, no calculations are necessary. Just keep your trading volumes low. If you are expanding your portfolio and thinking to ‘up your game', try setting your daily trading budget at 20% of available equity.
Leverage allows traders to open a larger position in the market. In other words, you can achieve larger profits, even with limited equity. It’s also one of the biggest enemies of risk management. Leverage is very attractive, but it comes at a price. High leverage makes your modest equity extremely sensitive to shifts in price. One wrong direction and your whole account can get wiped out.
Exness offers massive leverage for traders who prefer pairs with low volatility. Without leverage, it would be impossible to make significant gains from pairs that stay close to the ‘mean’. Try dividing your initial deposit by 10 for an aggressive leverage setting that won’t destroy your funds on the first volatile price shift. Traders with less than 2 years trading experience commonly suggest a 1:5 ratio for those not yet reaching for the stars.
So you’ve got your trading volumes right and your leverage is set to a level that balances your funds and your financial goals. You’ve got your risk management covered. Almost! Time to consider using pending orders. Most notable is the Stop Loss. While some traders don’t use Stop Loss or Take Profit and prefer to monitor their trades manually, these pending orders can be lifesavers when unexpected volatility occurs. There’s no real formula that stands out better than others. Set take profit first. How much profit would be ideal? How much are you willing to risk to achieve that profit? Stop Loss is also a personal preference, but try setting the Stop Loss similar to your take profit. If the Take Profit is set to activate at $20, perhaps a $20 Stop Loss feels right. Don't be too conservative. Market fluctuations can close an order before the real profits can start to build.
Hedging is not gardening. It’s the very definition of risk management, but there's more to hedging than meets the eye. If you live in the UK, then your income is measured in GBP. When GBP falls in price on the forex market, high street and even property prices change in the UK. You are losing money because you are living in a weaker economy. By trading against GBP, you’ll avoid losses and even profit from sudden falls in price. If the British economy picks up, your trades might lose, but your pounds will pick up the slack. This is one version of hedging.
Let’s say you have a EURUSD ‘Buy’ order and it’s falling fast. You could open a ’Sell’ order to counter the fall until the price stabilizes. This is also hedging. But beware: this is an effective way to protect a losing order, but you’ll have to pay spread for both ’Buy’ and ‘Sell’. So only do it as a last resort when the sky is falling.
Risk management in a nutshell
Profits will come, but so will losses. There will be some amazing highs as you see unexpected profits worthy of celebration, and they’ll be tragedies that will occur when you are not checking your trades. The goal of risk management is to make sure those losses are not catastrophic career enders. Ride the winning waves and get off the risky ones the moment you feel that risk is on the rise. Live to trade another day!
So there you have it. The basics of risk management. There are more details, tips, and tricks to know, but until you’ve tried and tested the basics, you simply won’t understand them. Now it’s time to open your Exness account and start doing some risk-free virtual trading. It can be exciting and far more entertaining than you might think. Give yourself a few days to get familiar with how the trading platform works. Keep your trades and virtual deposits at realistic levels.
The demo account offers the same trading conditions as the real accounts, so if you make it there you can make it anywhere. If you don’t do well or don’t feel the thrill, then perhaps trading is not for you. Either way, the only way to find out is to try.
Join Exness today and test your skills risk-free!
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