Why do you need a risk management plan in trading? 

Anyone who wants to become a trader has heard phrases such as “protect your trading capital” or “keep your losses to a minimum” and “risk only what you can afford to lose.” The common denominator of all the above is risk management, or else money management. For new traders though, these words seem to be more like a distraction than advice, but the sooner you understand the importance of these simple, rational arguments, the smoother the way to becoming a successful trader will be paved.

To put things into context you must first understand what a trading account represents.

The foundation of your trading activity is your trading account, which represents the funds you allocate specifically for buying and selling investments.

For most, this equals the sum of money available in all their trading accounts, however, some also include money from other budgets, such as the spare money in their bank accounts.

There is a critical point to make here: your trading account is not the sum of all the money you have got. Instead, it is the sum of everything you can afford to lose. You should never trade with cash set aside for household bills or other important and budgeted expenses. You should keep your trading account separated from the rest of your money to ensure you never overspend.

Trading should have its own budget!

Now that you know what a trading account represents, it is important to understand the importance of risk management.

Trading is all about managing risk, and the key to success lies in effective money management. This is what ultimately separates losers from winners, distinguishing mediocre results from extraordinary ones. As part of your daily trading routine, it’s important to incorporate fundamental money management principles like position sizing and exposure optimization. One crucial step in this process is identifying the right stop loss level and placing a stop loss order in the system or platform you’re using. Our “Move Stop” feature is designed to help traders automatically adjust/trail the stop loss order when the price hits a predetermined level. Once the “target price” is reached, the stop loss will be adjusted and relocated to the “targeted S/L” price.

However, it has become evident that most traders do not use fixed stop loss orders. Hence, the easiest way to get ahead of 75% of traders is simply by making correct use of such a basic risk management tool.

To achieve superior money management practices, consistency is key. Therefore, professional traders tend to say that a trade is considered a good trade if the initial plan was followed, and not based on the result of the trade. Consistency is primarily linked to the plan of action and NOT the trading outcome as most tend to believe.

Risk, in the sense of capital risked per transaction, is the only thing that a trader has control over, before even entering a trade. In other words, it displays the limits of what one is willing and can afford to lose. The word afford implies budgeting similarly to how we budget expenses in life.

The issue is that traders focus on the possible outcome – the potential profit – and not the risk involved, getting caught by surprise when the market is not moving in their favor.

A good question to ask is:

“Can I afford to take the risk? If yes, can I take it twice?”

The trick is to follow a basic money management rule: only risk an amount you would be comfortable risking again in the same trade, knowing beforehand that the outcome will be one more loss.

Living in peace with the risk you are exposed to, allows for emotions to be under control.

This freeing up of emotional weight, provides the appropriate environment for the creative part of the brain, to:

• Handle the uncertainty of the markets without deviating from the plan.
• Being more aggressive in risk when a good opportunity arises.

By really accepting the risk involved, in line with your risk tolerance, you will be able to manage it correctly.

1. Always use a stop loss knowing your risks beforehand and never widen your stop loss.

2. Do not automatically deposit money in your trading account after a series of losses. This will make it difficult to work out how much you have lost in a specific period such as a week or month, which could lead to you losing more than you originally budgeted for. Always have a plan and keep track of deposits and withdrawals.

3. Do not risk more than planned. It can be tempting to increase your risk amounts wildly when you have a larger balance after a series of wins, but stick to your plan, regardless of how large your account has grown.

4. Understanding how much to risk is probably the most important thing to consider. Always avoid betting over a certain percentage of your account balance. The trade frequency and your risk profile will determine your risk per trade. As a rule of thumb for active traders, do not risk more than 2% of your account balance at any given transaction. For many, 2% might not seem like enough, but it’s important to gradually start your account, especially when you start trading a new one.

5. Knowing when to stop trading is a crucial step that builds upon the previous tip. After utilizing your allocated percentage of your account in a trade, it is essential to possess the discipline to stop and exit. This will protect you from prolonging losses during a downward trend, and therefore save your account from a further drawdown. Also, if you feel yourself getting frustrated at any point, it is wise to step away to prevent making impulsive decisions.

It is also important to stop trading when you have won a substantial amount. Once you have added, for example, 10% to your account, stop for a while. When trading with money won, it is observed that the temptation is to take even greater risks. It is vital to be able to keep the money earned.

Trading can be very profitable; however, it is a marathon not a sprint. Ultimately, risk management is to the trader what the gas and brake pedals are to the driver. The skill lies surely not in reaching maximum speed, but in the ability to maneuver smoothly between obstacles, switching efficiently between acceleration and deceleration, remaining focused and composed through market cycles and keeping emotions out of trading decisions to protect your trading capital.

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