Gradually compounding your account by leaving your profits in the account and prudently increasing your positions in line with your increased capital is a more likely path to success than overtrading in the short term. Good risk management can also improve the quality of your trading decisions, by helping with your psychological approach to the market. Getting into a cycle of overconfidence followed by excessive caution is a common problem for traders.
Trading without risk management makes this more likely. Risk management involves limiting your positions so that if a big market move or large string of consecutive losses does happen, your overall loss will be something you can reasonably afford. It also aims to leave enough of your trading funds intact for you to recover the losses through profitable trading within a reasonable timeframe. The knowledge that your trading is backed by a good set of risk-management rules can be a big help in avoiding the cycle of euphoria and fear that often leads to poor decision-making.
Good risk management frees you to look at the markets objectively and go with the flow of the market, confident in the knowledge that you have taken reasonable steps to limit the risk of large losses. Many people are investors as well as traders. Trading normally refers to buying and selling in seeking to profit from relatively short-term price changes.
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Investing, on the other hand, involves holding assets to earn income and capital gain often over a relatively long term. It can be a good idea to plan, fund and operate your investment and trading separately, as each activity involves different approaches to strategy and risk management.
Wealth preservation should be a key consideration. It is best to limit your trading capital to an amount that you could prudently afford to lose if things go wrong. As previously discussed, this approach can have the added benefit of allowing you to trade without feeling too much pressure and improve your decision-making. One useful technique in deciding on how much capital and risk to allocate to trading is to conduct your own stress test. Calculate the likely worst-case loss if there was a very big market move or a large string of losses at a time when you have your maximum position open.
Limit your trading position to something you can handle in these circumstances. You should also make sure you have the liquid funds available to support your planned trading activities. Even if you are comfortable with the overall risk you take, it is best to make sure you have enough funds in your account, or available on short notice, to support your trading activities at all times.
Money Management for Trend Following
Finally, if you're new to trading, it can be prudent to start in a relatively small way and plan to increase your trading activities once you have developed some experience and a track record of success. Good traders always work out where they will cut the loss on a trade before they enter it. You can place a stop-loss order or guaranteed stop-loss order when you open a new position. Stop-loss orders are used to exit positions after the price moves against your position.
A sell-stop order is used if your opening trade was to buy and you are long the market. A sell stop order can only be set at a level that is below the current market price. If the market falls to the stop price you nominate, the order becomes a market order to sell at the next available price. Stop orders are often called stop-loss orders, but they can also be used to take profits. For example, a common strategy is to move your sell stop-loss higher as the market moves higher. This can be easily managed by applying the trailing stop-loss function.
A buy stop-loss is used if your opening trade was to sell and you are short the market. A buy stop order can only be placed above the current market price. If the market rises to the stop price you have nominated, the order becomes a market order to buy at the next available price. It is important to know that stops may be filled at a worse price than the level set in the order.
Any difference between the execution price and stop level is known as slippage.
Risk Management | Protect Profits & Limit Losses
The risk of slippage means that a stop-loss order cannot guarantee that your loss will be limited to a certain amount. We also offer guaranteed stop-loss orders GSLOs , which are an effective way of safe-guarding your trades against slippage or gapping during periods of high volatility. A GSLO guarantees to close your trade at the price you specified, for a premium. We refund this charge in the event that your GSLO is not triggered on your trade. It then becomes a market order and is sold at the next available price. In this case you would suffer slippage of 52 cents per CFD.
Slippage is particularly common in shares because markets close overnight. It is not at all uncommon for shares to open quite a bit higher or lower than the previous day's price, which makes it easy for slippage to occur on stop-loss orders. Slippage can also occur where there is not enough volume to fill your stop order at the nominated price. Even though stop-loss orders can sometimes be subject to slippage, they are a vital risk-management tool. It is good risk-management practice to have a stop-loss order in place for every position you open.
It is best to place the stop-loss order at the same time as you enter the trade.
Working out where to place stop-loss orders is an important element of your trading edge. One commonly used approach is to place stop-loss orders at the first place at which the strategy you are following can be said to have failed. Our trading platform calculates the potential approximate loss if the price falls to the stop level you set.
One of the things to consider when setting your position size percentage is how much of your trading capital you would be prepared to lose after a very large string of consecutive losses. This rule aims to defend your trading capital if you have positions open when there is a single adverse market event. For example, traders using fixed percentage position sizing of 1.
As discussed, share CFD positions can be more vulnerable than other markets to gapping through stop loss levels because they close overnight. To manage this risk, it can pay to have a limit on the value of the total of the net long or short company CFD positions you hold at one time.
Diversification is just as important for traders as it is for investors. We work in order to earn money to provide for ourselves and our family. The better we are at our job, the higher the pay we can command. It works the same way when it comes to trading. Your primary focus should be to do your job well — that means trading well, rather than being fixated on making profits. The better you trade, the higher the profits you can expect to make. Trading well means putting in the effort to do your own research, back-testing any new strategies you may want to employ, executing the strategies and keeping a close tab on your results.
It also requires you to recognise the mistakes that you are making and to learn from them. You can also get involved in a trading community in order to learn from others. IG hosts a community where traders of all levels can participate and learn from one another. As a trader, you need to focus on being a good trader. There are many different types of traders.
Some traders prefer day trading and may hold their positions from as little as a few minutes to a few hours.
Others are swing traders who may hold on to their positions for days or even weeks, as long as the market is still trending in their favour. Beyond just timeframe, there are also many different asset classes such as stocks, bonds, forex, indices, commodities and even cryptocurrencies now. As a trader, you need to understand yourself well. Are you someone who gets impatient easily, and think trading on an hourly timeframe would be too slow for you?
Or does an hourly timeframe seems too quick for you to make a good decision? These things matter. A strategy that works on an hourly timeframe may not work for a 5-minute timeframe or even a daily chart.
How to Build a Trading Risk Management Strategy
You need to understand your own personality, the time you can afford to put into trading each day and the type of assets that you want to trade. All these will eventually help you formulate your trading strategy. Depending on the asset classes that you trade, you will need to keep up-to-date on relevant news that could impact the prices of the assets which you are trading. For example, interest rates have a big impact on forex and bond prices while supply and demand, weather, government policies and economic cycles, will affect the prices for commodities.
However, the point is that you must be familiar with the kind of news that can affect the asset classes you are trading, and be prepared to take measures to protect yourself in the event that a piece of news is unfavourable to your trading position. If in doubt, you should stay out of trades whenever you anticipate an announcement is to be made. If you want to stay updated with relevant news, you can consider reading up on the news and analysis provided by brokers like IG. You could even set news alerts on Google Alert to send stories with relevant key words directly to your inbox.