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5 Essential Tips For Managing Your Risk

Risk management is at the heart of successful trading. While trying to maximise your rewards, you should focus on keeping your risks to a minimum. Successful traders learn to respect this element of risk and do their best to manage it throughout their journeys.

As with all disciplines, practise makes perfect so let’s take a look at five things you can do to improve your risk management before you place your next trade.

1. Understand What You're Trading 

Despite sounding straightforward, this is something traders often overlook. Let’s start with our contract or lot size.

When you’re trading, it's important to understand the contracts you’re dealing in and the differences between them. A standard FX lot has an underlying value of $100,000, whereas mini and micro lots have considerably smaller values.

You also need to be familiar with the tick sizes for the products you trade. The tick size is the value of the minimum price fluctuation for individual FX pairs, crosses or CFDs. 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.

Different contract sizes 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 US dollars in silver is also five times larger than that of gold at USD 50.00 vs USD 10.00.

2. Respect The Use Of Leverage

Margin FX and CFD trading are geared or leveraged products that allow individual clients to trade on equal terms with larger market participants. A single standard FX lot might have a value of $100,000 or similar, which isn’t a sum that most individuals have ready access to, or wish to trade with. 

To allow its customers to trade in that size, a broker leverages or gears the client's account, multiplying the value of their deposit by a specific ratio. By doing this, the broker effectively lends the client funds to allow them to trade.

  1. Clients place a deposit or initial margin against each trade they take
  2. Maintenance margin is then calculated based on the performance of those trades
  3. This margin is then debited from the client’s account to cover any running losses incurred on open positions.

We offer all our ASIC clients and professional clients in the FCA leverage of up to 500:1, which means that a deposit or initial margin of just $1,000 could control $500,000 worth of an underlying instrument. In our FCA jurisdiction the margin levels for retail clients are 30:1 for FX.

With this in mind, a modest sounding one percent move in the price of $500,000 worth of underlying can mean a P&L swing of $5,000.

So, if you have $6,000 in your account and you open this sort of position, then your maximum tolerance for loss is that 1% move or -$5000.00. However if you open a larger position, your account’s tolerance for loss can rapidly begin to decline. This is because increased initial margin requirement eats into your free balance, and the maximum move your account can afford drops sharply.

In summary, you need to be aware of the size of any position you take relative to your total account size and balances, as well being comfortable that you understand the level of margin applicable to any trade.

We offer our clients access to several calculators that can help you understand some of the calculations behind your trade. You can find these in your Secure Client Area.

3. Risk Managing Your Money

When you trade, you should only do so with risk capital, which are funds you can afford to lose and aren’t relying on to pay the bills. This is really important when you are trading on margin or in leveraged products. You’ll want to manage that capital sensibly and set yourself some ground rules because it’s likely to be hard won, and probably not that easily replaced.

You may decide to commit a small percentage, for example between 2% and 10% of your capital to each trade, and you might only allow yourself a maximum of three or four open positions at any one time.

Of course, no two traders’ circumstances are the same so you’ll need to research what’s right for you in terms of your style, strategy and risk appetite. Remember, that success in trading comes through longevity. Longevity is determined by how well you safeguard and grow your capital allowing you to stay in the game for the maximum length of time.

4. Risk Managing Your Positions

It’s equally important to manage the risks within your positions. For example, a portfolio of five open positions might be thought to offer a trader diversification. However, the opposite could also be true.

Imagine we’re long EURUSD, long GBPUSD, short USDJPY, long AUDUSD and long gold. We have five different positions, but all of them are shorting the US dollar. If that’s our intention, we could achieve it through a single position in dollar index or euro dollar.

If that wasn't our intention, then we’ve created a positional or market risk for ourselves that we weren't aware of. This means a positive catalyst for the US dollar could be bad news for our account.

Sizing your positions correctly and understanding the relationships between them is an essential part of trading. That’s where many traders go wrong because they don't adjust their trade size to reduce their risk and exposure.

Instead, they vary their stop-loss, setting it too close to the current market and increasing their chance of being stopped out, rather than reducing their trade size and keeping their stop at a more appropriate level.

Remember, trade size and stop-loss distance are two sides of an equation, each of which is a variable.

Stop-losses are there solely to protect your capital and limit your loss. If we ignore those stop-losses or move them further away from a losing trade, we increase our risk rather than reducing it.

Loss aversion can also lead traders to snatch at profits while running their losses, in the expectation that they will return to profits. Experience shows us that they rarely do.

5. Take Advantage Of Risk Management Tools

There's a lot of information to take in, however, there are many tools that are designed to help traders manage their risks. We look at an example of these below.

Correlation Matrix

The Correlation Matrix is just one of our Smart Trader Tools, which are available as an MT4/5 plugin. The Correlation Matrix is designed to allow traders to identify relationships between the instruments they trade and avoid risk concentration, and at the same time, allowing them to spot hedges or opportunities for diversification in their trading.

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.  
Pepperstone Smart Trader Tools - Correlation Matrix

The duration, sampling period and instrument list in the matrix can be configured, allowing you to focus on the instruments and timeframes that are relevant to you. You can find full details such as a user manual and a short instructional video on how to use the Correlation Matrix here.

Success in trading comes down to making the right choices. We may not have control over the outcome of a trade, but there’s a lot we can do to try to slant the odds of success in our favour every time we make one. Before you start trading, remember the five essential rules to managing risk

  1. Understand What You’re Trading.

    Set some ground rules about how you will allocate, run and protect your capital. Be sure you understand exactly what you’re trading, the size of the position you’re going to open and what each tick will be worth in that trade.

  2. Respect The Use Of Leverage.

    Know the level of margin or gearing for a planned trade and consider how that exposure stacks up relative to your account balances and other open positions.

  3. Risk Managing Your Money.

    Think about your total exposure and the potential loss in both individual trades and trades in aggregate if you have more than one open.

  4. Risk Managing Your Positions.

    Think carefully about how much you want to risk and how you will shape your trade to achieve that. Remember, you can adjust both your trade size and stop-loss levels to reach that goal, not just one or the other in isolation. Use the tools provided to you to help get a handle on your risk. It's really about creating a procedure you follow every time you trade.

With practise, this discipline will become second nature to you. Successful risk management will help you stay in the game for longer and have a much better chance of making a profit, which is why we all start trading in the first place.