Trading Risk Management

In the online trading world, not many people like to talk about risk. Can you blame them? Risk isn't as exciting as discussing profit opportunities. However, risk is an important part of trading and - in the right hands - it’s a valuable tool that can help you make trading decisions. In this short article we will discuss the importance of trading risk management for online traders and explain some of the strategies that investors use when faced with market risks.

What is trading risk management in finance?

In simple terms, trading risk management is a method through which investors identify, measure and analyze risk for various trading decisions, before choosing to accept or to mitigate it. Every time an investor assesses the risk involved in different investments before making a choice, trading risk management takes place.

Of course, risk is subjective. Some people find the concept of bungee jumping completely terrifying while others feel the risk is worth the fun. Investors need to figure out their own risk tolerance, as well as their investment goals, and act accordingly.

The risk of not managing risk

Never underestimate the importance of trading risk management. Miscalculated trading risk management can have substantial impact on companies and individual traders alike. Want a historic example? Miscalculation of credit risk by financial firms was one of the factors leading to the 2008 recession. By understanding and evaluating risk, you will be able to make better calculated decisions regarding various investments and could maximize your investment potential while avoiding excessive losses.

Different instruments, different risk?

Traditionally, some tradable instruments are viewed as ‘riskier’ than others. For example, share CFDs are historically viewed by some investors as riskier than commodity CFDs. Also, there are specific assets that are considered by some investors as so-called “safe haven” assets, since they are traditionally viewed as more stable. Such instruments include gold and the Japanese yen, instruments that historically tend to rise when the market experiences uncertainty and instability.

Why would traders choose so-called ‘riskier’ instruments? Because, historically, they have higher potential returns.

Does this mean gold will always rise during times of market uncertainty? Of course not. This is strictly theory and subjective view opinion. It's up to you to decide whether to accept it or not.

How to reduce risk

There is no clear answer for how to reduce the risk involved in trading, but there are many theories and strategies investors use to better manage risk.

The size of the investment depends on the size of your capital

It is important to remember that the capital you have will, to a degree, dictate how much you can risk. Why? Because no trader – not even the most professional, experienced, gifted trader in the world - achieves a 100% rate of trading success. When losses occur, you need to have sufficient funds in your account to enable you to keep trading. This is why some traders choose to limit the size of each trade to a fixed percentage of their capital. This way, they know that even if they lose a few trades in a row, chances are, they will be able to keep on trading.

Stop Loss

Stop Loss is a market order that allows you to limit potential losses. You simply set a rate in advance at which you want your deal to close automatically. Stop Loss is a great tool that can help you prevent excessive losses, and it’s particularly crucial for traders who manage multiple deals and cannot keep track of every rate around the clock. Even if you only open one trade, Stop Loss can be extremely useful. Let’s say, for example, that you want to trade Asian share CFDs – Toyota or Mitsubishi UFJ for example – but you live in Europe. You don’t want to stay up all night to monitor your deal, do you? That’s where Stop Loss comes in handy.

Note that on top of Stop Loss, you can also set a Take Profit order, which essentially “locks” your potential profits, automatically closing the deal at a specific rate.

Portfolio diversification

One of the quickest ways to reduce risk is portfolio diversification. By investing in various CFD instruments: Shares, commodities, indices and currencies, you can expose your trading portfolio to various markets and reduce risks. At iFOREX you have the opportunity to invest in over 750 CFD instruments and we’re constantly adding new instruments from different regions.

For a full list of our tradable instruments, visit our Trading Conditions page.

Risk/Reward ratio

The risk/reward ratio allows investors to compare the estimated returns of an investment to the amount of risk involved in achieving these returns. How is it calculated? You divide the amount the investor will lose if the price moves unexpectedly (AKA the risk) by the profit the investor expects to make when the position closes (the reward). Traders often use the risk/reward ratio with stop loss orders, so they can know their maximum potential loss in advance.

What is the ideal risk/reward ratio? The answer will vary dramatically between traders.

Expected return

Expected return is simply how much profit or loss an investor expects on a specific investment. We hope we don’t need to tell you that expected return is usually based on historical data and is not, in any way, guaranteed. By calculating expected return, traders can compare between investment opportunities as well as make decisions regarding market orders.

Want to know how expected return is calculated? We will provide you the math, but if it confuses you, don’t be concerned. You can get back to this calculation later on, or choose to ignore it altogether.

Expected return formula:

Probability of Gain

X

Take Profit % Gain

+

Probability of Loss

X

Stop Loss % Loss

Feel like we’re going too fast? Go back and check out our Getting Started page for some basic trading terms.

How Do You Make Trading Risk Management Calculations?

Risk is calculated with a simple formula:

Risk = Likelihood x Severity

This means that in order to have proper trading risk management, you calculate how good you feel about the chance of the negative thing happening and how harsh it is. You can rate Likelihood and Severity 1 through 5 each to figure out if that is a risk worth taking in your opinion and according to your balance.

For example, you might find that investing in gold has a lower likelihood of massive fluctuations so it's less risky. At the same time, you may find that forex risk management has a higher severity when leveraging forex, so you treat it as a riskier trade.

Negative Balance Protection

Now let’s take a break from math and ratios to discuss a policy that is absolutely essential to forex risk management: Negative Balance Protection. At iFOREX, traders’ losses can never exceed their investment, and the site maintains a legally binding Negative Balance Protection Policy that ensures clients’ accounts can never go into minus. Brokers that don’t offer this policy, expose their clients to excessive risks since the market is, and always will be, unpredictable.

Want a visual explanation of how Negative Balance Protection works?
Take a look at this short video.

You can find additional information about the steps iFOREX takes to protect its clients on our About Us page.

Leverage trading and risk

Leverage is a useful trading tool that allows you to open large deals with a relatively small investment. For example, with a $100 investment, you can open deals worth up to $20,000, using leverage of 200:1.

Your investment		Leverage		Your trading power
$100	X	1:200	=	$20,000

So, why are we mentioning this tool in an article about risk? Because while leverage boosts your trading power, it also involves greater risk to your investment and the higher the leverage you use, the higher the risk. Many traders love leverage and use it regularly, but it needs to be used carefully and after sufficient training.

Want to know more about leverage?
Take a look at this short video.

Choosing the correct trading strategy

Selecting the correct trading strategy is an important part of forex risk management, but how can you choose? We wish we could tell you what the best trading strategies are, but the simple answer is that there isn’t just one answer. Different traders choose to use different strategies depending on the size of their investment, their experience, their knowledge of instruments or just due to personal preferences. The important thing is that you take your time getting to know the various trading strategies out there and then pick the one that best fits your needs.

5 common mistakes in trading risk management

Making your first steps in the world of online trading can be challenging and mistakes are part of the learning curb. Here are some examples of common mistakes among beginner traders.

Not planning ahead

We know that you’ll be tempted to just jump straight in and open deals, but you always need to stop and make the necessary calculations. Think before you act.

Not using the free training

iFOREX has a variety of resources that could help you improve your trading skills, such as 1-on-1 training with a trading coach and a demo account for practice.

Opening deals of inadequate size

By “’inadequate’ we mean too large or too small. If you open deals that are too large, you increase the risk of quickly running out of trading capital, and if you open deals that are too small, it could take you a very long time to reach your goals.

Misusing leverage

Leverage is a great tool, but as we mentioned earlier, it involves risk and needs to be used carefully and after sufficient training.

Not doing research

There are many factors that impact the price of tradable instruments and in order to understand them, traders need to conduct adequate research. Free information is readily available on the news and market analysis – why not use it?

Find free information about upcoming economic events on our Economic Calendar.

Forex Risk Management

Trading has its risks. That is why trading risk management is important. By taking the right precautions and calculated risks. You can minimize it. However, there is a limit to what even the experts can forecast. Therefore, there is always some level of risk.

By taking the proper forex risk management steps, and by using risk as a tool rather than an obstacle, traders make more intuitive decisions. Trading requires the leg work to understand both the economic system and the various markets. Luckily, a lot of the information is available here on the iFOREX platform.