5 Rules of Risk Management Everyone Should Know
To some traders, risk management seems unnecessary. In reality, a few good risk management tips can save you a lot of money. Headway experts share what basic principles will improve your trading approach and help to navigate the markets consciously.
Rule 1. Always use a Stop-Loss order
This is one of the main rules in trading: “Always trade with stops.” In fact, among all types of orders, the Stop-Loss order is the most essential.
The Stop-Loss order is your primary defense line. No one can predict the market all the time. Even if you put in the required effort to analyze it, something might happen that causes the price movement to go against you. You start facing losses with every point the price moves against you. This is expected in any highly volatile market.
The Stop-Loss order will close the trade before your losses increase significantly. Placing a Stop-Loss order before entering a trade is one of the characteristics of professional traders. After analyzing the price movement of a currency, a professional trader will predefine the point where the trade will be closed in case of a loss.
Rule 2: Don’t lose more than 5% of your account in a single trade
It is important to ensure that the amount you potentially lose in a trade does not exceed 5% of your total account balance. For example, if you have a $10,000 account and decide to enter a trade, you will need to calculate the price at which you will exit the trade to avoid a loss of more than $500.
Let’s say you purchased 1 lot of GBPUSD for 1.2900, expecting the price to rise soon. In this scenario, you would place a Stop-Loss order for 1.2850 to limit your potential loss to $500, or 5% of your account balance.
However, if you bought 2 lots and the price reaches 1.2850, your loss would be $1000, or 10% of your account balance. In this case, you have two options: Either move the Stop-Loss order closer to the entry point (e.g., for 1.2875) or only purchase 1 lot.
Rule 3: Don’t trade against the trend
The key rule in analyzing financial markets is to follow the trend. This is an important factor in achieving success.
To adhere to this rule, do not enter trades against the general trend of the price movement. Your goal is to identify the general direction of the price movement of an asset (e.g., currency). Determine if the price is trending upwards, downwards, or remaining relatively stable. Once you have identified the trend, always enter trades in its direction, not against it.
When the price trend is upward, be a buyer of the currency. When the price trend is downward, be a seller of the currency. Following this rule is likely to result in more successful trades than losing ones.
If the price trend is side-way, do not trade the currency – you cannot determine whether its trend is upward or downward. Instead, wait until the direction of the price movement starts to move up or down. A side-way trend indicates that the market is uncertain and supply equals demand. This situation does not usually last long, and the market will soon determine a direction for the currency’s price movement.
Rule 4: Rely on analysis, not emotions, for entry and exit points
Before beginning actual trading, it is crucial to use a proven analysis method tested on a demo account. Trusting your intuition will only result in loss after loss, even if that intuition is correct sometimes.
Traders often fall prey to psychological influences before and during entering a trade. The most prominent emotional obstacles traders face are fear and greed, which can be detrimental to success in trading.
Greed may cause a trader to trade impulsively, without first conducting rational market research, and fear can prevent a trader from entering a trade, even when chart analysis suggests that the entry decision is sound. Additionally, fear of increasing losses may lead the trader to close the trade prematurely at a loss, even when analysis does not indicate the need to exit.
When the technical analysis of the chart confirms the price trend and if you find that the currency will rise, buy it. And if you find that it will fall, sell it, regardless of your “feelings” about it.
When you are in a trade and the indicators show that the price movement has started to move in the opposite direction, exit immediately, even if you “feel” that the price will return in the profitable direction for you. This feeling is mostly a result of conflicting emotions, not a form of future perception.
Rule 5: Don’t trade in unsuitable conditions and times
Chart analysis requires a lot of time, intellectual effort, and patience. If you are not physically, mentally, and intellectually prepared for trading, it’s best not to trade on that day.
Don’t trade when you are sick, or in an abnormal psychological or mental state, as that may lead you to make incorrect and hasty decisions.
If you have closed a losing trade, it is best to leave trading for a few hours so that you can regain your emotional and mental composure. Don’t resort to the approach of “I will not leave trading today until I recover what I lost!” as it may lead you to enter trades hastily and impulsively.
When you realize that loss in trading is a natural occurrence that must be paid from time to time, it helps you accept this loss.
Did you lose today? It’s okay; you can make up for this loss tomorrow or the day after. Trading in currencies and other assets is full of opportunities, and all we want is to take advantage of just one opportunity.
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