Risk management is one of the most important aspects and an essential tool of any successful trader. Like chess, it is a concept easy to understand, but difficult to master. Considering how important it is, it is amazing how often people fail to implement it in moves that can (and usually do) result in massive losses for themselves and their clients.
Risk Management in a Nutshell
On the most basic level, risk management is a series of if/then loops, serving one purpose, making sure that your bad trade doesn’t devolve into a catastrophic one. Regardless of how promising a trade looks, a trader should always have a plan dealing with sudden and unpredictable market movements. This is especially important when dealing with volatile markets, but that doesn’t mean that stable ones should be considered safe enough to forgo a proper risk management analysis.
Why Bother with Risk Management?
According to Nick Lewis, head of risk at Capital Spreads, a successful trader must possess two essential skills. The first and more obvious one is the ability to understand the market and the forces behind it and predict its movement. The second, often neglected, especially by younger traders, is aptness to grasp all the risks that come with making a trade and possible countermoves that can help them minimize their losses or even make a profit if things turn sideways.
Risk Management and p/l
Understanding what is risk management and how it should be managed in relation to p/l is the ultimate goal of any risk management strategy worth its salt. P/l is shortened for profit and loss statement, the end product of traders’ labor. IT is the best and only measure of how successful they are and improving their profit margin is the sole purpose of risk management. In order to do so, traders have several tools at their disposal, each designed for a different scenario. Learning when to use each of them is a skill that can take a lifetime to develop properly.
This is an excellent tool for every trader, but beginners will get the most use out of it. More experienced traders can make this analysis on the fly since it has become second nature to them because this is the first step in determining whether a trade is a good one. It boils down to how much money you need to make to justify the risk of investment. To simplify it further, would you risk one million dollars to make a profit of one dollar? How much you need to earn on investment often depends on personal choices and some traders are willing to risk more than others, but beginners would do wisely to have a set limit and stick to it.
The most used risk management strategy is a stop loss. It does exactly what it claims, stopping trade and selling assets to prevent them from bleeding your account dry. There are several variants of this tool. The most basic one includes a trigger price. Once an asset reaches it, it triggers an automatic sell, which lets trader recuperate at least a portion of the invested funds. Other versions include a guaranteed stop loss and a trailing stop loss, which use different triggers for their actions.
A diversified portfolio is perhaps the closest thing to a guaranteed profit one can get while trading on any market. The logic behind it is that it is safer to have several smaller investments than one large one. Even if you incur losses on one or two assets, there are others in your portfolio that will keep you afloat. As a fail-safe mechanism, diversification is a great tool, with one major downside and that is it doesn’t yield as much profit as other strategies would.
It is important to understand that even though proper risk management can minimize your losses, it can’t prevent you from making a bad trade. Some people tend to think that it is an all-powerful magic wand which makes their trades bullet-proof and nothing can’t be further from the truth. Just like any other tool, it is only as good as the skill of the person using it.