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5 Essential Tips for Managing your Risk

Risk management is at the heart of successful trading. While It's true that risk and reward are said to be opposite sides of the same coin, the successful trader learns to respect risk and does their best to contain it.

Keeping trading risk to a minimum while trying to maximise trading rewards could be thought of as the trader’s mantra. As with all disciplines, if we practise it often enough, it should soon become second nature.

1. Understand The Products You Trade 

Sounds straightforward and sensible, doesn't it? But this information is often overlooked or ignored by traders. Let's start by considering contract or lot size. When you are trading, it's imperative that you understand the contracts you are dealing with and the differences between them. A standard FX lot has an underlying value of say $100,000 whereas mini and micro lots have a considerably smaller value. We need to also be aware of the tick sizes for the products we trade. The tick size is the value of the minimum price fluctuation within individual FX pairs, crosses and other products. For example, the tick or pip size in a standard lot of AUDJPY is 1000 JPY. The same figure in EURUSD is USD 10.00. 

Of course, if you trade in tenths or hundredths of a lot, then those numbers are scaled down accordingly. It follows as well that a different contract size will also mean a different minimum tick size or change in valuation. For example, the standard lot size in Silver is five times larger than that in Gold. That differential means that the minimum move in USD dollars, in Silver, is also five times larger than that of Gold at USD 50.00 versus USD 10.00.

2. Respect The Use Of Leverage

Margin FX and CFD trading are by their very nature geared or leveraged for no other reason than to allow retail clients to trade on equal terms with larger market participants. In other words, a single standard FX lot might have a value of $100,000 or similar. 

That is not a sum that most retail customers would have ready access to, or wish to trade with. 

To allow their customers to be able to trade in that size, the broker leverages or gears the client's account, multiplying the value of their deposit. In doing so, the broker has effectively lent the customer the necessary funds to allow them to trade. Customers place a deposit or initial margin against each trade or position they take. Based on the P&L performance of those trades, maintenance margin is then calculated and debited automatically from their account. 

Clients who hold open positions overnight will also pay interest or rollover swaps on the underlying value of their positions. Those fees are effectively the overnight interest paid by clients, on the money lent to them by their broker.
Here at Pepperstone, we offer our clients leverage of up to 500:1 which in theory means that a deposit or initial margin of just $1,000 could control $500,000 worth of an underlying instrument. However, a modest sounding one percent move in the price of $500,000 worth of underlying, means a P&L swing of $5,000. Thus if you have $6,000 in your account and you open just such a position, then your maximum tolerance for loss is that 1% move or $5000.00. If you open a larger position, your accounts tolerance can rapidly begin to decline as larger initial margin requirement eats into your free balance and the maximum move your account can afford to fund drops sharply. In short, you need to be aware of the size of any position you take relative to your total account size and balances as well as knowing the level of margin applicable to any trade.

3. Risk Managing Your Money

When you trade, you should only do so with risk capital. That is, funds which you could afford to lose and are not relying on to pay the bills. This is doubly important when you are trading on margin or in leveraged products. That's because in the worst case scenario you can lose more than the value of your account. Your risk capital is likely to have been hard won, and probably not that easily replaced. 

As such you will want to manage it sensibly and set some ground rules. For example, you may decide to commit a small percentage (such as 2% and no more than 10%) at any one time of the capital to each trade. Under those terms, you would only allow yourself a maximum of five open positions at any one time.

Of course, no two traders’ circumstances will be identical, and you will need to decide what guidelines are right for you. Success in trading comes through longevity. That longevity is determined by how well you safeguard and grow your capital, allowing you stay in the game for the maximum length of time.

4. Risk Managing Your Positions

It's perhaps even more important to manage the risks on your positions and exposure. For example on the surface, a portfolio of five open positions might be thought to offer a trader diversification. 

But in fact, the opposite could be true. 

Imagine we are long EuroDollar, long Cable, short Dollar Yen, long AUDUSD and long Gold.  We have five different positions. But all of them are shorting the US Dollar. If that is our intention then perhaps we could achieve it through a single position in Dollar index or just EuroDollar. If that wasn't our intention, then we have inadvertently created a positional or market risk for ourselves, that we weren't aware of. That means that a positive catalyst for the Dollar would be bad news for our account (under these circumstances) indeed. 

Sizing your positions appropriately and understanding the relationships between the positions is an essential part of trading. This is where many traders go wrong simply because they don't adjust their trade size to adjust their risk and exposure. Instead, they often vary their stop-loss bringing it far too close to the current market. Thereby dramatically increasing their chances of being stopped out prematurely rather than scaling down their trade size to allow them to place their stop at a more appropriate level. 

Remember that Trade Size and Stop Loss Distance are two sides of an equation, each of which is a variable. It's also highly advisable to get your trading psychology correctly set. For example, stops losses are there solely to protect your capital. However, if we ignore those same stop losses or move them further away, we are increasing our risk rather than reducing it. This behaviour is known as loss aversion, and it can also lead traders to snatch at profits when they appear, yet at the same time continue to run their losses in the expectation that they will return to profits. Experience shows us they rarely do.

5. Use The Risk Management Tools Provided

That’s a lot of information to take in and action, but there are many tools that are specifically designed to help traders manage their risk both regarding their positions money and exposure.

We look at two examples of these below.  

Pepperstone's Correlation Matrix

The Correlation Matrix is one of Pepperstone’s Smart Trader Tools which is available as an MT4 plugin. The matrix is designed to allow traders to identify the underlying relationships between the instruments they are trading thus avoiding risk concentration and allowing them to identify potential hedges or opportunities for diversification in their trading and positions. 

Correlations are the mathematical relationships that exist between two variables. The correlation matrix visualises these relationships for a trader, within what we might think of as a heat map.  The duration, sampling period and list of instruments included in the matrix can all be individually configured, allowing you to focus on the instruments and timeframes that are relevant to you. 
Pepperstone Smart Trader Tools - Correlation Matrix

You will find full details, a user manual and a short instructional video on how to use the Correlation Matrix here.

The latest addition to risk management tools on offer to Pepperstone customers is Risk Calculator from Autochartist,  available as an MT4 plugin. This new tool brings risk management and trade rightsizing, into the heart of the MT4 platform. Risk Calculator allows you, the trader to configure a potential trade from both ends. That is you can set up a prospective trade from the standpoint of an entry-level, lot size, stop loss distance or even a specific percentage of an account balance. What’s more, you can instantly see what a change in one or more of these variables will mean to the others. For example, when you run Risk Calculator you can quickly adjust your potential entry and stop loss levels for a possible trade, simply by moving the green and orange lines on your MT4 chart. You can then set the cash amount you wish to risk in that trade, hit the calculate button. Risk manager does the rest and shows the volume or size of trade that will allow you to meet those criteria. You should soon become familiar with this intuitive tool and the different risk calculations you can perform with it. You can see Risk calculator in action here in this video from Autochartist.

Next steps

Success in trading comes down to making the right choices. We may not have control of the outcome of a trade, but we can try to slant the odds of its success in our favour, every time we trade.

Before you trade set some ground rules about how you will allocate,  run and protect your capital. Make sure you understand what you are trading, the size of the position you intend to open and what each tick will be worth in that trade. You need to know the prospective level of margin or gearing contained within a planned trade. Consider how that exposure stacks up relative to your account balances and any other current open positions. You should consider your total exposure and the potential loss for both individual trades and trades in aggregate if you have more than one position open.

Before trading, think carefully about what you want to risk and how you will shape your trade to achieve that exposure. Remember that you can adjust both your trade size and stop loss level to reach that goal, not just one or the other in isolation. Use the tools provided to help get a handle on your risk. It's really about creating a procedure that you follow every time you trade. It will become second nature to you, and that discipline should ensure that you stay in the game and have much better chance of making a profit. Which, in the end, is what trading is all about.

For more of Pepperstone market analyst Darren Sinden's content, you can check out his Daily Market Update (key market news in minutes) or follow him on Twitter.