Successful trading requires a good strategy that allows you to act on your risk versus reward criteria. When most people first begin to trade, they focus on entry points, and spend less time figuring out how to manage their risk.  Once you become cognizant to the importance of risk management you will start to use a number of tools that will allow you to maximize your risk adjusted returns.

Taking Risk

When you invest in the capital markets, you are getting paid to take risk. The more risk you take, the larger the potential reward.  The more gain you want to experience the more pain you must be willing to take. To manage your risk, you want to start by determining your risk versus reward parameters.

Risk versus Reward

The problem that most novice investors face is that they have unrealistic risk – reward parameters. One of the best ways to determine if your risk versus reward parameters are achievable is to back-test your strategy.  If your strategy is purely discretionary, with specific parameters, then you might consider paper trading for a while to see if the strategy works, and what is a realistic risk versus reward profile. If your strategy is systematic, then evaluating how it performed in the past is a great way to see how much you have to risk to achieve your goals.

Managing Risk

To apply risk management in trading, you need to formulate a strategy where you determine your exit criteria prior to entering a trade.  Once your trade is set up to initiate, you can use multiple methods to determine where you will get out. The most important level is where you will stop out, which determines how much you will risk on your trade.  Your stop out level could be a percentage loss, a level on a chart, or just a specific currency amount such as $100.

Depending on your strategy, you can then back into your take profit level.  If your strategy is geared to catching trends, where the gains are much larger than the losses, you probably want a multiple of your stop loss percentage.  For example, a trend follower might be looking to make 15%, and willing to lose 5%.  A scalper, who wins more than they lose might be willing to risk 50 pips to gain only 40 pips.

You also can consider different chart levels to help you manage your risk.  If you believe based on the chart of the USD/CAD that the exchange rate is going to move higher, you might consider a purchase with a stop loss below the 50-day moving average. If you are willing to risk 2-big figures (1.2760 to 1.2560), you might consider taking profit as a multiple of that targeting the 1.3340 level which are the highs made in June.  Your gain would be 4.8 big figures which is nearly 2.5-times the risk you are willing to assume.

Prior to entering a trade, you should determine the risk you are willing to take on, and drive your rewards as a function of your risk. This will lead to a sound investment strategy and will not leave you in the dark once you have a trading on your books.

Categories: Stock Market