In this article, we’re going to explore the number one risk management technique for traders.
We’ll explain how important risk management is for your trading business.
And also describe the difficulties it presents and why it’s often overlooked.
There are several things that traders can do to master this technique.
When implemented, it will help improve your trading results.
This article will be broken down into the following areas:
A Wikipedia article describes risk.
The definition it gives is: “the possibility of losing something of value such as physical health, social status, emotional well-being or financial wealth”.
It explains uncertainty as: “a situation which involves imperfect or unknown information”.
And further explains risk as: “a consequence of action taken in spite of uncertainty”.
Based on these explanations, we can say risk must be an integral part of life. Due to the uncertainty posed by life itself.
We’re all exposed to varying degrees of risk. 24 hours a day.
Some risks are involuntary. Unknown to us during the course of living our lives.
Other risks are voluntary. Known but accepted. Crossing a road that signals a red stop sign is an example of this.
Risk doesn’t need to have negative connotations.
Look at all the gadgets around you right now. For those inventions to have occurred, people were willing to take risks.
The inventors must also have been willing to challenge the status quo of their time. The world wide web is an example. And there are lots more.
These voluntary risks would be accompanied by many failures and successes.
It’s these consequences of taking risks that FX traders are very familiar with.
The impact of those consequences are also well known.
A Berkeley education study found over 80% of FX traders consistently lose money. And only 1% achieve predictable, long-term profits.
These are stark statistics.
It shows the odds are against traders from the outset.
The study shows many of these failures are down to poor risk management.
But, there are ways to limit risks and their impact on your trading. To improve your chances of success you need to utilise them.
The Importance Of Risk Management
Risks are part of life.
For an FX trader, risk is an integral part of the trading business.
Proper risk management can be used as a trading edge.
What does this mean?
To make money, a trader must make the decision to open a trade. They must be willing to accept that the trade could lose money.
These are risks which every trader must acknowledge. Accepting these risks will help you trade without fear.
Trading without anxiety helps the trader get into the perfect mind set. This mind set is often referred to as ‘the trading zone’.
Mark Douglas explains this as a state of mind where the trader is totally in tune with trading. The trader acts instinctively.
The Economic Times describes risk management as:
“The practice of identifying potential risks in advance. Analysing them and taking precautionary steps to reduce/curb the risk.”
Traders should remove uncertainty and ambiguity from their trading.
But how can this be done? The very nature of forex trading equates to risk and uncertainty.
The key is in defining and planning for all known trading risks that are within the control of the trader from the outset.
A solid risk management structure will help you trade freely. It also reduces the likelihood of you making rash decisions. It eliminates guess work.
A proper risk management structure significantly reduces stress and anxiety. These emotions can cause traders to fail.
A well-rounded risk management structure also helps cultivate a positive trading environment.
They’re all inter-related – and form the foundations of a successful trading business.
Each of these areas has its own risk factors that must be managed.
For example, traders must be in full control of the costs of running their trading business.
This includes subscriptions, account size, leverage and salary.
Traders must be in control of analysis from both fundamental and technical perspectives.
And must also be in control of deciding when they are fit to trade.
You need a clear plan for all known risks that are within your control.
This cannot be stressed enough. Each area must be analysed.
All risks need to be anticipated and identified. Various scenarios need to be planned for.
You need to decide whether the benefits outweigh the potential risks. If they don’t then you need to discard any unnecessary risk.
Finally, you need to accept all risk that has been assessed.
This process will give you belief in your own trading ability.
Difficulties Of Managing Risk
Most hedge funds or banks have a dedicated risk management department. Retail traders do not.
They generally work alone. And may have access to a few individuals or online trading groups.
A retail trader’s mind set is different.
They focus on looking for the best technical indicator. Or a great strategy that’ll reap huge rewards.
Trading education companies often perpetuate this by using misleading advertising. They give the illusion of quick profits and can be hard to resist.
These expectations can influence a trader’s emotional state.
Emotional states such as greed, fear and anger are natural. But it’s not emotions which are the risk.
Not realising when emotions are influencing trading decisions is the biggest risk.
And having no process to deal with this increases risk further.
These emotions can involuntarily influence decisions with negative impacts.
Yet, traders continually overlook risk management.
Why? Risk management isn’t as appealing as the latest technical indicator. It doesn’t compare with specific money-making systems.
Many traders aren’t aware of the importance of risk management. Because they’ve never received the right education.
It’s very easy for small mistakes to escalate into bigger problems.
Traders may avoid cutting losses on a negative trade. They ‘hope’ the trade will turn around in their favour.
This gets compounded by the effects of the trader’s emotional response. With no risk process to follow, the trader is at the mercy of their emotions. This can lead to bad decisions – such as increasing financial risk and ignoring important rules.
By the time the trader is rational again, the situation has spiralled out of control. Usually at great financial and psychological cost.
Because risk management is a choice.
Risk management is a technique that is totally within the power of every single trader.
The Best Risk Management Technique Explained
What’s the single most important element to any retail trader’s business?
It’s not fundamental analysis. Or technical analysis. Neither is it how much money you have in your trading account.
It’s you, the trader.
Think about it. Retail traders generally trade alone.
So, without you as the trader, your trading business cannot function.
This last sentence should ring alarms bells.
Imagine if you’re tired, emotionally charged, distracted or inadequately educated. You can’t possibly perform to the best of your ability.
It’s the trader themselves that actually pose the biggest risks to their overall success.
Thus, the number one risk management technique is to risk manage yourself.
The point of risk management is to cut out sources of uncertainty and ambiguity.
Your focus needs to be on eliminating risk, uncertainty and ambiguity posed by the trader.
We’ll divide this risk management technique into two areas. Business management and self-management.
Traders need to understand the risks posed in this area. Then they can control and divide their financial resources.
You can do this by mapping out a complete risk and money management framework. Then it can be interwoven into your business trading plan.
The details that need to be covered include identifying the following:
- Minimum salary needed to live.
- Fixed costs of operating the trading business.
- Trade size and leverage.
- Highest acceptable costs.
This produces a monetary value. The figure then becomes your profit target.
This profit target can be broken down into realistic timescales. These can be daily, weekly, monthly or quarterly goals.
The benefit is that you now have these risks defined as process goals with a clear focus.
This will help with your trading performance psychology.
It also makes it easier to determine whether the trading business is on track.
During periodic reviews of each segment, you should re-analyse your financial commitments. And re-adjust goals as necessary.
This ensures the profit target and process goals remain aligned. And also match the true business financial costs.
Traders need to understand risks posed by their physical and psychological condition.
Personal resources are finite. You need to control and divide them effectively.
Traders must create a risk structure surrounding how to manage themselves.
You need to cover a variety of details. One of these is education. Obtaining the best training and knowledge for FX trading is important.
Another important requirement is time. Dedicating enough time is fundamental to developing your trading skills.
Your trading environment is important. The environment must be conducive to professional trading. All distractions and clutter removed.
You need to decide what hours you will trade. You should also decide when not to trade. Having a clear plan will save you from unnecessary losses.
Being aware of your current physical state also helps. Take breaks, eat healthily and get plenty of rest.
Make time for mindfulness. Check your emotional state on a regular basis. Monitor how you’re feeling. Also pay attention to what and how you’re thinking.
All these things provide you with a blueprint. This blueprint is your self-management risk plan.
You can use this plan to set goals and targets. These can be broken down into realistic daily, weekly, monthly or quarterly goals.
This will help you to clearly define your risks. You’re creating self-management process goals with a clear focus.
Creating risk management structures improve your trading psychology.
During periodic reviews of each segment the trader re-analyses. Highlights areas that need more focus for improvement.
It becomes easier for you to identify things that are not working. It allows you to make small identifiable adjustments where necessary.
All risks identified under business and self-management must be within full control of the trader.
Traders can ensure they’re systematically limiting self-risk in the best way possible.
Mastering The Self-Risk Management Technique
Mastering the art of creating a business risk management structure is straight forward. This is because it is monetary based. There are no involuntary ambiguities involved.
Mastering the technique of self-risk management is where the difficulties are.
Especially at the psychological level.
The internal workings of traders’ psychologies cannot be seen. But their affects are often felt very strongly.
Becoming skilled in risk managing this area requires effort.
Success will come down to practice, dedication and discipline.
Traders must employ discipline to practice the techniques. And dedicated enough to persevere.
This is no different to the practice traders put in to become skilled at reading price charts.
The goal is for traders to get to a point where self-risk management is second nature.
Tips To Help Master The Technique
- Engage in deliberate practice. Encourages targeted learning. It’s a process top athletes use.
- Set learning goals.
- At the end of the period, ask yourself what you’ve learnt.
- Track and evaluate your progress.
- Stay open to learning. Focus on improving consistently.
- Become process driven. Reduces emotion-driven decision making.
- When opening new trades. Follow the process designed to achieve that.
- To have a good trading day. Follow your daily trading routine created to achieve that.
- Engage in mindfulness. It has many benefits.
- Be aware of your physiology before, during and after trades.
- Make notes of your heart rate, breathing, posture, gestures. Try to understand what triggers preceded any change.
- Often reveals unconscious processes which occur repeatedly. And will highlight a process you can create to curb any risks.
- Be aware of your thoughts, what you imagine and when.
- Make notes. Are they positive or filled with dread? Do you imagine positive trade outcomes or not?
- Use positive self-affirmations to help limit this risk.
- Visualise yourself in positive trading situations.
- Self-affirmations must be believable to your psyche.
- When repeated, they can overlay and drown out negative voices.
- Visualisation can help alter your self-belief system.
- And help your unconscious processes become conscious.
- Practise meditation, deep breathing, pausing before reacting regularly.
- This encourages your deliberate thought processes to be used more.
- And helps limit risks from unconscious urges and impulses. Jumping into trades too soon is an example.
Traders who master these techniques see their trading ethos shift for the better.
And give themselves a significant edge over traders who ignore self-risk management.
Effective self-risk management is one type of trading edge. It can help catapult traders into becoming ‘consistently profitable’.
In this article, we’ve explained why managing yourself is the number one risk management technique.
We’ve covered the importance of risk management. As well as the difficulties that surround it.
We’ve also provided tips for you to start practising this important technique.
Remember that trading without effective risk management is simply gambling.
You can’t control what the FX market will do.
But you can control what you do.
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We value all feedback and will use them to create new articles and content in the future.