Tip 2: Find Trades with Solid Risk/Reward Ratio.
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- Top Stories
- Risk Management Techniques for Active Traders
- Risk Management Techniques for Active Traders
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Top Stories
Although high risk exposure may be devastating, the opposite extreme is not a good option as well. If a trader enters positions with too little money, then his performance will suffer and the results may be discouraging as he misses on good opportunities. Of course, if you are unsure at the start, you will enter smaller positions, but eventually you will reach that amount. It is crucial to remember that traders should always place themselves in their comfort zone, thus you need to risk as much as you think you can emotionally handle.
Being unable to digest the higher risk exposure in a certain situation will lead to emotional distress and result in a hasty decision you might regret later. The worst thing that can happen to a novice trader, well actually to every trader but the more experienced ones will take it much more easy, is to see his account getting wiped.
Risk Management Techniques for Active Traders
The chance of that happening can be calculated with a simple enough formula measuring the so-called Probability of Ruin. However, first we will need to pull out some statistical data from the traders performance, on which to base it. Using that same data we can calculate another key figure — the Expected Return. Expected return is a number based on four values derived from your trading history, which shows how much money you can expect to make if you continue to trade using the same strategy and money management system. These four values are the following:.
His Expected Return would then be: 0. Of course, all those calculations need to be based on a data base rich enough, so that the numbers are smoothed out. The strategy will allow you to enter into big profitable trades, and the losses from losing trades will be less. Successful trades require making some calculated risks. You cannot make a profit without taking any and suffer some losses along the way. The amount of risk you take depends on your risk appetite. In other words, you should consider how much you can afford to lose to make a profit.
For instance, if you seek 80 percent profit during a year, you should be prepared for a 20 percent loss. You cannot realistically expect a percent profit with 0 percent chance of losses. You need to accept that losses and gains have an unshakable link in any trade. You should know your risk profile — aggressive, moderate, or conservative — as it will help determine your trading strategy.
This strategy will result in maximizing your ROI at the risk of incurring large losses. Most traders would want to adopt a moderate or conservative risk profile. This strategy involves taking some risks but adopting an overall balanced approach over the long run. Examples include combining some volatile securities with blue-chip stocks or securities with stable returns.
A typical strategy entails investing some of the funds in growth and some in dividend-paying stocks. Margin requirements should not be a big consideration in trading. Your main consideration should be the trend and profit-making potential from a given trade. Whether a margin increases or decreases, should not affect your money management decisions when trading. The money management strategy should not be the same for all contracts or shares. You should make rules depending on the specific situation of a particular security.
The fundamental and technical analysis results should dictate your money management strategy. You should use different formulas to determine trends for different commodities. If you use a constant strategy, you will lose out on the money-making strategy.
Risk Management Techniques for Active Traders
Often, a particular strategy that has been successful with one type of security turns out to be disastrous for another. Moreover, the required strategy should change with time depending on specific market conditions. You should always use stop-limit order when trading stocks or any other commodity. Stop-limit orders generally work well in minimizing losses.
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With a stop-limit order, an order will cancel automatically once a specific price level is reached. You should always set the stop-limit order for every trade. Most experts suggest placing the limit near support and resistance levels. A support level is the price level at which investors start purchasing security, thereby establishing a floor below which a price is not likely to fall. A resistance level is the opposite of support level representing prices at which investors tend to sell a security, thereby establishing a ceiling above which price is not likely to rise.
Support and resistance levels can be determined using technical analysis tools.
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The reason is simple: just like eating healthy and staying fit, money management can seem like a burdensome, unpleasant activity. It forces traders to constantly monitor their positions and to take necessary losses, and few people like to do that. However, as Figure 1 proves, loss-taking is crucial to long-term trading success.
Although most traders are familiar with the figures above, they are inevitably ignored. Trading books are littered with stories of traders losing one, two, even five years' worth of profits in a single trade gone terribly wrong. Typically, the runaway loss is a result of sloppy money management, with no hard stops and lots of average downs into the longs and average ups into the shorts.
Above all, the runaway loss is due simply to a loss of discipline. Most traders begin their trading career, whether consciously or subconsciously, visualizing "The Big One" - the one trade that will make them millions and allow them to retire young and live carefree for the rest of their lives. In forex , this fantasy is further reinforced by the folklore of the markets. But the cold hard truth for most retail traders is that, instead of experiencing the "Big Win", most traders fall victim to just one "Big Loss" that can knock them out of the game forever.
Traders can avoid this fate by controlling their risks through stop losses. The reality is that very few traders have the discipline to practice this method consistently. Not unlike a child who learns not to touch a hot stove only after being burned once or twice, most traders can only absorb the lessons of risk discipline through the harsh experience of monetary loss. This is the most important reason why traders should use only their speculative capital when first entering the forex market.
When novices ask how much money they should begin trading with, one seasoned trader says: "Choose a number that will not materially impact your life if you were to lose it completely.
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Now subdivide that number by five because your first few attempts at trading will most likely end up in blow out. Generally speaking, there are two ways to practice successful money management. A trader can take many frequent small stops and try to harvest profits from the few large winning trades, or a trader can choose to go for many small squirrel-like gains and take infrequent but large stops in the hope the many small profits will outweigh the few large losses.
The first method generates many minor instances of psychological pain, but it produces a few major moments of ecstasy. On the other hand, the second strategy offers many minor instances of joy, but at the expense of experiencing a few very nasty psychological hits. With this wide-stop approach, it is not unusual to lose a week or even a month's worth of profits in one or two trades. To a large extent, the method you choose depends on your personality; it is part of the process of discovery for each trader.
One of the great benefits of the forex market is that it can accommodate both styles equally, without any additional cost to the retail trader. Since forex is a spread -based market, the cost of each transaction is the same, regardless of the size of any given trader's position. This cost will be uniform, in percentage terms, whether the trader wants to deal in unit lots or one million-unit lots of the currency. This type of variability makes it very hard for smaller traders in the equity market to scale into positions, as commissions heavily skew costs against them.
However, forex traders have the benefit of uniform pricing and can practice any style of money management they choose without concern about variable transaction costs. Once you are ready to trade with a serious approach to money management and the proper amount of capital is allocated to your account, there are four types of stops you may consider. Equity Stop — This is the simplest of all stops.