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Risk Management Guide

Mastering Risk Management: The Cornerstone of Successful Trading

We often hear that risk management is crucial for successful trading, but what does that really mean? Essentially, there are two key types of risk management to consider: the risk on each individual trade and the overall financial risk to your trading account. Let's dive in.

Managing Risk on Individual Trades

First, let's talk about managing risk on individual trades. Every time you place a trade, you should identify a point where, if the market moves against you, you'll accept that your initial view was wrong and cut your losses. This is a fundamental aspect of risk management: you don’t want to hold onto losing trades indefinitely, watching your losses grow until they potentially wipe out your entire trading account—or worse.

One of the simplest ways to manage risk on a trade is by using a stop-loss order. For example, if you buy in a market at 100 because you believe the price will rise to 150, you might place a stop loss at 85. This strategy acknowledges that the trade might not go as planned and commits you to taking a loss if the market drops to that level.

Professional traders understand that risk management isn’t just an option; it’s a core part of their trading strategy. Knowing when to exit a trade if things don’t go as planned is essential.

Protecting Your Trading Account from Financial Risk

The second aspect of risk management focuses on protecting your trading account from a string of losses. Even the most successful strategies can encounter losing streaks.

When we first start trading, many of us tend to risk too much relative to our account size. Imagine someone has £1,000 in their trading account and risks £500 on a single trade. If that trade goes south and hits the stop loss, they lose £500—half of their entire account. You don’t need to be a math expert to see that this approach doesn’t effectively manage risk. Just a couple of bad trades, and the account is wiped out.

A more sensible approach to financial risk management suggests risking only 1% to 3% of your account on any single trade. This doesn’t mean setting your stop loss just 3% away from your entry point; it means that if the trade goes wrong, only 3% of your account value should be at risk. Of course, larger losses can occur if the market gaps through your stop loss due to major news or other unexpected events.

For instance, if you bought at 100 with a stop loss at 85 and have £10,000 in your account, you might decide that your risk management strategy is to lose no more than 3% on any given trade. In this case, if the trade hits your stop loss, your maximum loss would be £300.

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