Money and Risk Management

Even with solid risk management strategies, there's still a chance that things can go wrong. If your account loses more than 30%, recovering from that loss becomes a significant challenge. In such situations, some traders may take on even greater risks, which often leads to deeper losses.

To benefit from a winning strategy over the long term, it's crucial to stay in the game. Poor risk management can bring your trading to a halt after a large market move or a short-term string of losses. Risk is unavoidable in trading, but preserving your capital is essential to making money.

A risk-managed trading approach acknowledges the inherent risks but focuses on limiting them in the short term to maximize long-term opportunities. The absence of risk management is one of the most common reasons traders fail.

Margin Trading: A Double-Edged Sword

Margin trading amplifies both potential profits and potential losses, making it vital to limit your exposure to significant market moves or extended loss streaks.

While risk management may sometimes reduce short- to medium-term profits, the temptation to abandon it is often highest after a successful period. However, a single large trade taken on after a winning streak can wipe out your hard-earned gains and more. It's common to experience many successful trades with smaller positions, only to face inevitable losses when you decide to take on larger positions.

A steady, controlled trading approach is more likely to lead to long-term success. Gradually compounding your account by reinvesting profits and increasing positions in line with your growing capital is a better path to success than overtrading in the short term.

Good risk management also enhances the quality of your trading decisions by improving your psychological approach to the market. Overconfidence followed by excessive caution is a common cycle for traders, and trading without risk management increases the likelihood of falling into this trap.

Risk management involves setting limits on your positions so that if a significant market move or extended loss streak occurs, your overall loss remains manageable. It also aims to preserve enough of your trading capital to recover losses through profitable trading within a reasonable timeframe.

Risk Management Guidelines

Establishing Effective Risk-Management Rules

Having a solid set of risk-management rules can significantly help you avoid the emotional highs and lows that often lead to poor trading decisions. Good risk management allows you to approach the markets with an objective mindset, confident that you've taken reasonable steps to mitigate the risk of significant losses.

Determining Your Trading Capital

One of the first decisions you'll need to make is how much capital to allocate to trading. Many individuals are both investors and traders, holding long-term assets like stocks or real estate while also engaging in short-term trading to profit from market fluctuations. Since investing and trading require different strategies and risk management approaches, it’s wise to manage them separately.

Consider the following factors when determining your trading capital:

• Your overall financial situation and needs
• Your trading objectives
• Your risk tolerance
• Your previous experience as an investor or trader

Preserving your wealth should be a key consideration. It’s advisable to limit your trading capital to an amount you can afford to lose without significant financial strain. This approach not only reduces pressure but also improves your decision-making process.

Performing a Personal Stress Test

A useful method for deciding how much capital and risk to allocate to trading is to conduct a personal stress test. This involves calculating the potential worst-case scenario—such as a large market move or a series of losses when you have your maximum position open.

Consider whether you can afford this loss financially and handle it emotionally, keeping in mind that losing all your capital is a possibility. Limit your trading position to an amount you can manage under these circumstances. Additionally, ensure you have enough liquid funds available to support your planned trading activities. Even if you are comfortable with the overall risk, it’s essential to have sufficient funds on hand to maintain your trading positions.

If you’re new to trading, it’s prudent to start with a smaller amount of capital and gradually increase your trading activities as you gain experience and build a track record of success.

Always Use a Stop-Loss Order

Successful trading requires balancing risk and reward. Savvy traders always determine their exit point for cutting losses before entering a trade.

The Next Generation trading platform is designed to support a risk/reward approach by allowing you to place stop-loss or guaranteed stop-loss orders when opening a new position. Stop-loss orders help you exit positions when the market moves against you.

Sell Stop Order: Used if you bought and are long on the market. This order is set below the current market price, and if the market falls to the stop price, the order becomes a market order to sell at the next available price.

Buy Stop Order: Used if you sold and are short on the market. This order is set above the current market price, and if the market rises to the stop price, the order becomes a market order to buy at the next available price.

Understanding Slippage

It's important to note that stop orders may be executed at a price different from the level you set due to slippage. Slippage occurs when the market price moves rapidly, often due to major news events, causing your order to be filled at the next available price rather than the price you specified.

For instance, if you set a stop loss at $10.00 and a sudden price drop occurs, your order might be executed at $9.48 instead, resulting in slippage of $0.52 per unit.

Using Guaranteed Stop-Loss Orders (GSLOs)

GSLOs offer protection against slippage or gapping during periods of high volatility by guaranteeing that your trade will close at the specified price. This protection comes with a premium charge, which is refunded if the GSLO is not triggered.

Why Slippage Happens

Slippage often occurs when prices gap due to major news or when the market opens with a significant difference from the previous day's closing price, especially in shares. Limited trading volume can also cause slippage if there's insufficient volume to fill your stop order at the desired price.

Despite the potential for slippage, stop-loss orders remain a critical risk-management tool. It's a best practice to set a stop-loss order for every position you open, ideally at the same time you enter the trade.

Advantages of Stop-Loss Orders

• Risk Control: They help you manage risk by reducing the likelihood of large, unexpected losses.
• Disciplined Trading: They encourage you to plan where to cut losses before entering a trade, reducing the temptation to hold onto losing positions.
• Risk/Reward Assessment: They enable you to evaluate the potential profit against the original risk, guiding better trade decisions.
• Time Management: Since stop-loss orders are triggered automatically, you don’t need to constantly monitor your positions.

Using stop-loss orders can significantly improve your trading discipline and overall success by helping you manage risk effectively.

In the Australia 200 index chart above, the moving average aligns with the previous resistance level, which now serves as a potential support level.

Adopt Fixed Percentage Position Sizing

Determining where to place stop-loss orders is a crucial part of your trading strategy. A common approach is to set stop-loss orders at the point where the strategy you are following can be considered to have failed.

Fixed percentage position sizing involves calculating the size of each new trade so that the potential loss at the initial stop-loss level represents a fixed percentage of your account balance, such as 1% or 2%.

For example, if a trader has $10,000 in their account, they might set the size of each new position so that the potential loss at the initial stop-loss order does not exceed 2% of their capital, or $200.

The trading platform helps by calculating the approximate potential loss if the price falls to the stop level you’ve set.

Advantages of Fixed Percentage Position Sizing:

• Logical Risk Management: It’s a systematic way to align your position size with your risk tolerance.
• Capital Preservation: As your positions automatically decrease in size when you experience losses, it helps protect your trading capital. This method prevents erratic position sizes, reducing the risk of holding large positions during losses and small ones during wins.
• Gradual Growth: It allows you to gradually increase your position size as your account grows, helping to steadily increase your trading capital while maintaining consistent risk levels.

When determining your position size percentage, consider how much of your trading capital you’re willing to risk after a significant series of consecutive losses. For instance, with a 1% risk per trade, you would lose 13% of your capital after 14 consecutive losses.

With a 2% risk per trade, 14 consecutive losses would result in a 25% loss of your capital.

How using differing position size percentages can affect your capital

Set a Cap on Your Open Positions

To protect your trading capital, it's wise to limit the number or value of positions you hold at any given time, especially when unexpected market events occur.

For instance, if you use a fixed percentage position sizing of 1.5%, you might decide not to have more than 10 or 15 positions open simultaneously. Assuming there's no slippage, this would cap your potential loss at around 15% or 22.5% of your trading capital if every position went south. The exact limit should be based on what you’re comfortable with, considering your personal circumstances and trading style.

As we've mentioned, share CFDs can be more susceptible to gaps through stop loss levels, particularly because they close overnight. To manage this risk, consider setting a cap on the total value of your net long or short CFD positions at any one time.

For example, if you limit the total value of your net long share CFD positions to 300% of your account balance, then a 7% overnight drop across all positions would result in a loss of 21% of your account balance. If you limit it to 200%, a 10% drop would equate to a 20% loss.

Diversify Your Holdings

Diversification isn’t just for long-term investors; it’s crucial for traders too. Avoid putting all your eggs in one basket.

You might decide to limit yourself to no more than two net long or short positions in closely related instruments. For example, if you hold six long and four short positions, you’re net long two positions.

Closely related instruments could include:

• Forex pairs involving the same currency (e.g., EUR/USD, GBP/USD, USD/JPY)
• Shares within the same industry and listed on the same exchange (e.g., Australian bank stocks)
• Similar commodities (e.g., wheat, corn, soybeans)

Limit Losses from a Single Strategy

Traders often use multiple strategies. It's important to cut off a strategy if it starts eating away too much of your capital.

A practical approach could be to set tighter limits for new strategies, while being more lenient with a strategy that’s proven itself over time. This is especially true if you’re familiar with its risk profile, including how many consecutive losses it might incur and the likelihood of stop loss slippage.