While trading can offer plenty of benefits, it can also be a risky business if you fail to protect your investments. But as with every problem, there is always a solution - risk management.
Proper #risk #management strategies can help you reduce the effect of your trading mistakes while also protecting your account against unexpected market movements.
Before we delve into more details and tell you about 5 core risk management strategies, it is critical to understand a key concept: risk tolerance.
Risk tolerance dictates how traders approach investing.
Risk tolerance reflects how much you afford to risk when trading. Experts suggest focusing your investment approach on this concept, meaning adapting your strategies and trading systems depending on your take on risks. For more info on risk tolerance, check out our article Risk tolerance and trading – finding the perfect balance.
Keeping that in mind, let us look at 5 common risk management strategies that you can employ in your trading:
1) Asset Allocation – never keep all your eggs in one basket!
Asset allocation deals with the amount of money you have in various assets: stocks, bonds, commodities, currencies, etc. According to financial analysts, one of the goals of asset allocation is to avoid taking too much risk in just one asset class and/or sector. Creating a versatile portfolio requires a solid asset allocation strategy because not a single asset is devoid of any risk.
Take a moment to imagine how risky it would be to have all your assets in one sector. If that sector takes an unexpected hit, you might be in trouble. However, if you spread your trading portfolio, you will no longer rely on a single asset class to perform well and will be protected from big swings in a single asset.
As mentioned above, it could be wise to diversify by asset sector and not just by asset class.
For further study - How to build a diversified trading portfolio.
2) Master the art of using Stop Losses.
A common way of protecting your account against volatility risks is by using stop losses. After you learn how to use them appropriately, based on the nature of the asset you are trading, you can shield yourself against unforeseen events or inefficient trading. For these reasons, stop losses should be at the core of your risk management strategy.
How does a stop-loss order work?
The fundamental principle of a stop loss is to close your open position if the markets go too far against you before losing too much and endanger your account. Experts advise us to set a threshold for our positions - the maximum amount we are prepared to lose before closing the position. This threshold can usually be expressed as a percentage of the initial purchase price.
Enrich your knowledge about stop losses and other vital market orders - Stop Loss, Take Profit, Trailing Stop & other orders - what's all this?
3) A different kind of Stop that goes both ways – The Trailing Stop.
In addition to classic stop losses, you can also utilize trailing stops in your daily trading.
For a long position (when you take a *bullish approach), trailing stops work as stop losses following the asset's price as it moves up but stays put if the price starts to fall. For a short position (a *bearish approach), it is the other way around. Essentially, a #trailing #stop allows you to lock-in your earnings as they pile up by protecting you against significant market shifts against your position. Note that the price of the stop-loss adjusts with the stock price fluctuations.
*Do not know what bearish and bullish market approach mean? Check out our in-depth article on Understanding the bull and bear markets!
You can lift the Stop every time your traded asset hits a new high to protect the earnings you made up until that point. One more thing here: trailing stops can work automatically with most brokers/software, or they can be manually set up at the desired levels.
4) Optimizing Your Risk Level – Position Sizing.
In short, position sizing refers to setting the proper quantity of units to buy or sell in any asset you might trade.
Determining the right position sizing for you can make the difference between success and failure, making it critical for your risk management strategy. If you learn how to use it the right way, you can avoid large drawdowns in your trading capital while keeping your account safer. Ultimately, it is all about your risk tolerance and how much you are prepared to give away vs. how far you are aiming with your potential winnings.
According to some analysts, the size of your position should be proportional to the **expected outcome.
**Expected outcome refers to the odds of having a winning trade multiplied by the win amount, plus the odds of posting a losing trade multiplied by the loss amount.
Learn how to create a robust trading plan and get ready for conquering the financial markets!
5. Play it to your strengths – a jack of all trades is a master of none.
"A jack of all trades is a master of none," says an old quote allegedly originating in 16th century Britain. And this rings true in the trading world too.
Many traders might live under the impression they can outfox the markets. This mindset can turn out costly amidst volatile markets, where a single tiny mistake might have serious consequences, especially if they do not have enough experience at trading outside their comfort zone.
To avoid falling into this trap and bite more than you can chew, take your time to analyze what you can and cannot do. Carefully evaluate your trading knowledge, assessing how far it could be safe to venture and what markets you would like to tackle. After you are done, you will most likely have a clearer picture of your current potential and your goals and objectives. Sometimes it could be wiser to stick to one, maybe two trading strategies you got used to instead of trying out new things that you have not had the proper time to test thoroughly.
Sources: investopedia.com, thenbalance.com, forbes.com, babyips.com.
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