Risk Mitigation: 3 Strategies to Help You Prosper
A trader is faced with many complex decisions in their day-to-day analysis of markets. Where to buy and sell? What technical indicators and timeframe to use? Risk mitigation and how to manage risk? Most professional traders believe it is the last phrase which captures the key fundamental in trading and how to gain success over the long-term.
Traders should always think about preventing losses before making profits. After all, if proper risk management is not employed, a trader who has generated significant profits over an extended period of time can lose it all in a just a few bad trades.
If you can learn a few key risk mitigation strategies, you have a great chance of keeping hold of your trading capital and of being more profitable. By using simple trade and risk management techniques, you should enjoy more controlled and less stressful trading.
1: Risk Reward Ratio
Any time we put our capital into a trade, there is a risk that we may not get that back and that trade will fail. But without taking some risk on, we have little chance in making money, so we expect a return that compensates us for any potential losses. In theory, the higher the risk, the more we should receive for taking the trade. Conversely, we expect to receive less if there is a lower risk attached to that trade.
The risk/reward ratio tells us our possible reward we can make for every dollar we risk on each trade. This allows us to compare the expected returns with the amount we must risk in order to earn those gains.
For example, a ratio of 1 to 5 signals that the trader is willing to risk $1 in the hope of earning $5 from the trade.
In the trading arena, while less advanced traders may think a 1 to 1 ratio is worth a shot, the seasoned amongst us know that 2 to 1 is the bare minimum risk/reward, with 3 to 1 being the most preferred starting basis for every trade.
How often do I have to be right?
It’s worth thinking about a 3 to 1 ratio for a moment.
A risk/reward ratio like this allows a trader to have a success rate of 33%. To paraphrase one of the most successful traders of all time, Paul Tudor Jones, you can actually be a complete fool and crucially, wrong on your trading 66% of the time and still not lose money. Similarly, a 5 to 1 risk/reward ratio allows you to have a hit rate of 20%, so you can be wrong 80% of the time and still not lose.
Determining your risk/rewards
When calculating your risk reward ratio on a particular trade - by dividing your net profit (the reward) by the price of your maximum risk - you need to set upside and downside targets to your trades beforehand, based on current prices. For example,
- You buy 10 shares of Apple at $100 and place a stop-loss order below the market at $75 to ensure your losses do not exceed $250.
- You place a take-profit order above the current market price at $175 as you believe the new iPhone release will push the shares higher.
- You are therefore willing to risk $25 per share to make an expected return of $75 per share, which means you have a 1 to 3 risk/reward ratio.
If your calculation is below your risk/reward threshold, you could potentially lift your downside target to achieve an acceptable ratio. But if you can’t accomplish this, it is best to move on and look for another trade opportunity.
The optimum risk/reward ratio will vary among different traders and their strategies. Market volatility may also dictate what ratio is best to use in different market environments when considering risk mitigation reward ratios. In fact, it may prove quite hard to find good trade ideas once you start incorporating risk/reward.
However, by trusting your trading system and waiting for trades that fit your criteria, you are integrating one of the key characteristics of a professional trader into your own execution process.
2. Risk per Trade
Determining your correct position sizing allows you to know what your maximum risk is on every trade you enter. The correct size will both maximise your opportunities as well as protect your account.
The general trading rule of thumb is to only risk one to two per cent of your total account balance per trade. Achieving long-term success in trading is about preserving your trading capital and that means you should be sensible about how you allocate it out. Many reputable trading platforms have a position size calculator to help you select the right position size. This will involve figuring out your risk percentage, pip cost and lot size.
The temptation, especially when you’re having a good run and confidence is high, is to increase your risk per trade. Yet every experienced trader knows that markets can turn on a dime and with just a few oversized losing trades, your account is under water and your confidence badly knocked.
By following this basic rule means you can withstand a stretch of losses if and when they come. Indeed initially, especially for new traders, it may feel like your trading account balance is hardly moving, even when you have a streak of winners. But using correct position sizing can help prevent quick and possibly fatal drawdowns in your trading account.
3. Cumulative Exposure
Many experienced traders hold multiple positions on their trading book, which may solely be in the product they trade, or across several asset classes. For example, an interest rate trader may buy and sell numerous different futures contracts across the short-term interest rate curve. This means they will always be monitoring and mitigating their risk, weighting it according to their views on the monetary policy of the futures contracts they are trading.
Just as their positions may be spread across the curve so diversifying the risk held, other traders who hold positions in various different asset classes will need to calculate their risk across those classes, in different sectors, segments, geographic regions or industry. The greater the trader’s market exposure, the greater their total market risk in that specific investment area.
It follows that a high concentration of market exposure in any one asset class can lead to large gains (or losses) if that area sees increased volatility.
New traders can often fall into the trap of opening several positions in the belief that they are spreading their risk. However, very often the opposite is true as some markets which appear unconnected at first glance, are in fact highly correlated and can move in the same direction and sometimes very quickly.
For a trader who only trades Forex, this may appear simpler as no different asset classes or sectors are involved. But this can be too simplistic in fact because all Forex pairs are correlated to some degree through their relationship to the US Dollar. As the global reserve currency, it is the benchmark that all other Forex prices are calculated from.
Forex traders who have several positions will therefore need to understand their market exposure to each currency they are trading and whether they are doubling up their longs or shorts in individual currencies.
A trader may like the economic fundamentals of the Chinese economy and so wish to go long AUD/USD as a play on the economy outperforming.
She might also believe the EUR is overbought and think the technicals of EUR/AUD are ripe for a pullback, so she goes short in this pair.
This means her cumulative exposure is double long AUD which may be what she intended inadvertently, but may also hurt her positions if all of a sudden, some weak domestic Australian data is released which results in AUD selling off strongly.
Her fundamental opinion on the Chinese economy may have been correct, and her technical view on EUR accurate, but the cumulative exposure in AUD has impacted on both positions.
A disciplined approach to risk mitigation can keep you on your trading journey for longer. Even the best traders are not able to predict each and every risk that presents itself. But they can try to reduce those risks they identify.
Knowing how much to risk will make you feel more assured in your trading. More importantly, you will always know how much you will lose on each trade. Remember that the overriding question should not be how much I will make from this trade, but rather how much I will lose.
By incorporating some basic rules into your normal daily processes and consistently following these risk mitigation strategies in a trading plan, traders can negotiate their chosen markets with a higher degree of confidence and ultimately become more profitable.