Risk control makes up an essential part of successful trading. Effective risk management requires not only careful monitoring of the size of the risk, but also a strategy to minimize losses. Understanding, how to control the amount of risk allows a trader, beginner or experienced, continue trading even then, when unexpected losses occur. One of the authors of articles for Stocks & Commodities offers guidance on risk control.
Since every trade is subject to a certain degree of risk, applying some general principles of risk management will reduce potential loss. Some generally accepted axioms of risk control are listed below and can be applied by all., who when – either traded or is thinking about it.
The rule 1: Do preliminary homework.
Do your homework before the deal – it's a duty, which cannot be replaced by anything. There is a well-informed seller for every buyer, and there is a well-informed buyer for every seller. Everyone tries to maximize their profits. Before putting your money at risk, you must have a solid, well thought out reason, why do you want to buy that, that someone else wants to sell. In addition to all, trade – This is a game “building up capital”. Ask yourself, what i know from that, what the seller doesn't know (or buyer)? Be careful and portray some degree of respect for the person., located on the other side of the counter.
You must be clear about, what financial risk you can face at any time. Part of the homework includes assessing the potential loss in the event, if the market starts moving against you on 5%, 10% or 20%. Doing some preliminary homework on trading will help you calculate the worst possible outcome as well., potential exposure to risk.
You can reduce your risk, if you limit yourself to deals, to carry out an examination which is in your power (this is doing preliminary homework). We know one trader, who rushed to buy orange juice futures after a sudden cold snap in Florida. Only later did he realize, that frost-damaged oranges can be sold to produce orange juice. In the reality, sudden cold snap increased, rather than reducing the supply of orange juice, and oversupply pushed orange juice futures prices down hard. If trader did some preliminary homework, he would know, what to expect.
The rule 2: Create a trading plan and stick to it.
Each trader must create his own trading methodology. A trading methodology or model can be based on fundamental factors, technical indicators or a combination of both. The methodology should be extensively tested and reworked until then, until she demonstrates a desired and lasting positive result. Before investing money, make sure, that your trading methodology is reasonable and profitable.
An important part of your trading plan is to set a cap on the amount, which you can lose. If you reach this limit, exit the game. Stick to your trading plan and avoid impulsive trades. If you don't follow your plan, then you don't have it.
A trading plan helps you identify and evaluate key factors, that affect your transactions, and can be an important teaching tool for follow-up transactions. A smart trading plan will give you the confidence you need.. Also unlikely, that with a definite plan, you will trade impulsively.
However, do not blindly follow the trading plan.. If you don't understand, what the market is doing, or your emotional balance is somewhat disturbed, close all positions.
Creating your own trading strategy, do not listen to a broker and do not invest based on market advice or rumors. Your money will be at risk. Before you trade, do your homework and think about your own justification for transactions.
The rule 3: Diversify.
Portfolio risk is reduced through diversification. Don't bet all your money in one trade. Diversify your exposure, trading one position no more, how 1% – 5% your capital. (Contracts with different expiration dates for the same contract count as one line item.) Consider diversification in different markets and with different trading systems.
To be effective, diversification should include securities, which do not correlate strongly with each other (that is, do not move in the same direction at the same time). High positive correlation reduces the benefits of diversification. Closely monitor the connections between all your positions, unbalance and adjust your portfolio.
Predefined stop orders limit your risk and reduce your losses in fast moving markets. Adopt a strict stop loss rule, for example, quit the game quickly, if you lose 5%-7% – and follow it.
The rule 4: Don't invest all your money.
Before you make a deal, make sure, that you have sufficient capital, to compensate for unexpected loss. If the opportunity looks unexpectedly profitable, then, maybe, you are too optimistic. Markets are usually rarely that good, how they may seem at first glance. If the market turns down unexpectedly, then it is reasonable to have at your disposal some capital, to compensate for small losses or additional margin requirements. Some capital, dedicated for additional purchases, reduces stress, reduces the need to take unnecessary risks and, usually, helps, sleep better at night :).
The rule 5: Apply stop – orders.
Predefined stop orders limit your risk and reduce your losses in rapidly changing markets. Adopt a strict stop loss rule, for example, quit the game quickly, if you lose 5%-7%. Even the most experienced traders, not to mention the lucky ones, apply stop – orders, to limit the amount of risk. Make a commitment to quit the game, if your plan doesn't work. Stop lights are needed to, to protect you. Use them, when you start the game.
Some traders use timed stop signals. If the market does not behave like this, as you expected, exit the market, even if you haven't lost money. Timed stop lights remind you, that you should exit the market, if you are not sure about, what is really going on.
The rule 6: Trade on trend.
unlikely, that you will suffer a loss, if you follow the market trend. Market direction doesn't matter, while you have an open position according to the emerging trend. If you have an unsuccessful position, then systematically reduce your risk.
The rule 7: Make mistakes and suffer losses.
An important aspect of risk control is the ability to recognize, that you are wrong, and quickly exit the game, even if it means losing money. Even the best traders lose money from time to time. But we all hate to admit our mistakes, therefore this rule is difficult to follow. The axiom is simple: let profits accumulate and reduce losses. Reduce your risk, if the market moves against you. Do not add to a losing position in the hope of making up for the loss. If you don't understand, what the market is doing, exit the game. Also, do not immediately after a losing trade make the next trade in the hope of recouping. – we must first cool down emotions.
The rule 8: Trade, taking protective measures.
Paul Tudor Jones has a great thought on trading in football terms: “The most important trading rule is, to play great in defense, not great in attack”. Think first about, what you can lose and compare it with the possible gain. It is better to take into account the possibility of negative developments in advance and make a plan, than then change everything after a fait accompli.
Constantly admit the thought that, that the market may move against you – and prepare for this in advance. Calculate the maximum possible use of the loan. If it's necessary, adjust stop levels – signal there, where is more suitable. Create a market exit plan. Therefore, when the market starts to move against you, you will be ready for this.. Protect then, what do you have.
The rule 9: Do not bargain.
Reduce your risk by cutting down on trades and keeping rates low. Be picky about your risks, to which you are exposed. Limit trades to one, which is the most attractive. It will force you to do preliminary homework and reduce impulsive and emotional transactions.. Since there will be fewer transactions, you will be more patient. Fortunately, fewer transactions also reduce the amount of commissions, which you pay.
The rule 10: Control your emotions.
All traders experience severe stress from time to time and suffer losses. Anxiety, disorder, depression, sometimes despair, are part of the game on the market. Part of managing risk is the ability to control these emotions.. Don't let emotions drive your trade. Focus on being, what are you doing. Trade informed, rational decisions, not emotions and fantasies.
Communication with other traders is one way to maintain control over your emotions.. Other traders understand the problems, that you have encountered and can provide important emotional support, when you lose courage. It helps to understand, that you are not alone, and that others have encountered and experienced similar problems.
The rule 11: If in doubt, exit the game.
Personal doubts suggest, that something is wrong with your trading plan. Get out of the market quickly, if a:
• The market behaves irrationally;
• You are not sure of the position;
•You don't know, what to do;
• You can't sleep at night.
Before putting money at risk, you must be sure that, what you are doing, And, what's good for you.
Conclusion
There are four main steps to risk management:
– Full understanding of, what are the risks of the transaction.
– elimination, if possible, risks, in which there is no need.
– Be choosy about, what risks can you expose to a deal.
– Act quickly, to reduce the risk, if the market moves against you.
For many traders, the key to controlling risk is the ability to cut losses before, than they will lead to ruin.
Edwin LeFevre, author “Reminiscences of a Stock Operator” wrote: “Enemies of the trader, which lead him to ruin: ignorance, greed, fear and hope”. Though these inner enemies will never be defeated, effective risk control techniques can minimize their negative impact. Rational risk control strategy, vice versa, should lead to smaller and less expensive unprofitable transactions.
