How can traders manage risk?

Trading has the potential to be incredibly lucrative. Whether you’re trading stocks, commodities, forex, or cryptocurrencies, all these financial markets offer the potential for explosive growth. However, it can be challenging to assess which direction the market will move in, especially when it comes to executing short-term trades where unknown factors have the potential to play havoc with the market and cause unpredictable price movements.

As such, it is imperative for traders to understand the markets in which they are trading in as this enables them to manage any potential risks and losses. Being aware of the risks is vital, ensuring traders avoid unnecessary losses and optimise their trading experience.

Types of risks

Although it may not seem important, it is imperative to evaluate the legitimacy of the broker you choose to operate with, and ensure they are a reliable counterparty. This can go a long way to limiting the risks that come with trading. For example, when you purchase contracts for difference (CFDs), you are purchasing a contract with a broker – not the asset itself. Therefore, traders must be 100 per cent certain in the knowledge that the broker they’ve chosen to operate with is capable of making good on the value of that contract.

There are two types of trading risks. The first is volatility. This is characterised by unexpected fluctuations in the prices of assets and is defined as the rate at which pricing rises or falls given a particular set of returns. All assets are subject to a certain level of volatility, and the regularity and size of price changes varies tremendously across different asset groups. In fact, volatility is actually predictable in some markets. For example, the cryptocurrency market is well known for its fluctuations, characterised by frequent and generally significant changes in price. This volatility is desirable for some traders as it fosters greater profit margins. However, it sharply increases the potential for large losses to be made. There is even the potential for seemingly vanilla trades to go wrong due to market volatility. In terms of how to spot incoming market fluctuations, there are of course a number of indicators. This includes economic volatility, geopolitical tensions, and changing policies. Nevertheless, these are not standalone, with markets susceptible to a wide range of upsets that are incredibly challenging to forecast.

The second type of risk associated with trading is leverage. When it comes to purchasing and trading CFDs, leverage is typically involved. This is where traders stake only a percentage of the value of the underlying asset they wish to trade on but accept exposure to the full value of the profit and loss that comes with the asset’s price changes. Therefore, enabling traders to take sizeable positions for comparatively less trading capital, thus providing an opening for big wins and substantial rewards. However, there is also the risk for similarly significant losses. For example, you can open a £100 trade on an asset worth £1,000, using leverage of 10:1. This means that if the assets value increase by 10 per cent, the trader’s money will be doubled. But if it drops by just 10 per cent, the trader will lose all of their stake. This balance of high risk and high reward necessitates careful management.

Ways to control risks

To make sure the risks associated with trading are limited and remain under control, there are several techniques traders can use. This begins with ensuring the right broker is chosen. As previously mentioned, selecting the right broker is a vital step, particularly in terms of managing counterparty risk. For those people who are just starting out on their trading journey, they should look to open a trading account with an established name that is well regulated in a variety of jurisdictions. There are further benefits to trading with a reputable partner. For instance, higher-quality brokers will generally have a wider range of risk management tools and offer better features, which will allow traders to manage the buying and selling of assets in a better, more sophisticated manner.

What’s more, as a trader, one simple way to ensure you aren’t running the risk of accumulating excessive losses is to keep your capital-to-trade ratio under control – that’s the amount of capital left exposed to losses in trades compared to the total amount of capital traders have available to themselves. In this respect, a sensible rule for traders to follow is to not exceed a capital-to-trade ratio of 10 per cent, and not to risk more than two per cent of your overall capital on a single trade. Nevertheless, this doesn’t mean always taking very small positions. It means traders should hedge their risks on whatever positions they choose to take. A simple way to do this is through a stop-loss order. This is an instruction that is executed automatically when certain conditions are met. In the case of a stop-loss order, the position is sold at a predetermined rate – below the current market price for a long position, or above the current market price for a short position. The purpose of this is to stop losses from falling below a certain point, therefore setting a limit on how much an investor can lose on a trade.

Finally, for those individuals new to trading, or those who are looking for extra support, certain brokers offer risk management tools that provide thorough protection against losses for a set period of time. For example, there are tools which provide traders with a simple way to safeguard their investments. Requiring just a small fee – similar to the premium on an insurance policy – users have comprehensive protection against any losses for a predefined timeframe. These risk management tools differ from stop-loss orders in the sense that it allows users to stay in the trade, riding out any short-term drops in value and benefitting from a positive overall momentum of the position. Therefore, if the market moves in a different direction to what was originally expected, users are able to recover their losses, only losing the cost of purchasing the protection.

This is an exciting time to be entering the world of trading, and it’s no surprise to see a growing number of people looking to expand their horizons and try their hand at it. However, trading does not come without its risks. As such, there are several techniques which can be employed to make sure the risks associated with trading are controlled, rendering the trading experience smoother and more enjoyable. From beginners to experts, having these tactics in your arsenal will render you a savvier, more confident trader.