Risk Management Supply and Demand Trading Strategy

Why Is Risk Management Important?

Risk management is the most important topics about trading. Why is it important? Well, trading is a business of making money, and to make money you have to learn how to manage your capital and your potential losses.

This is one of the most neglected areas in trading. Many traders are anxious to get right into trading without choosing the right lot size for their positions. When you trade without a risk management plan, you are actually gambling. You are not looking at the long-term return on your investment. Instead, you are only looking for that "winning lottery ticket."

You can have the best trading system in the world, and still lose all your money in the market. Risk management will protect your capital from unnecessary losses and make your account profitable in the long run.

Always Have a Trading Plan

Many newbies begin trading without a trading plan. This is one of the main reasons why they keep losing all their money in the market. Even with a trading plan, if it lacks proper money management, they still lose all their capital.

Strict money management is essential to achieve long-term profitability in the market. The high level of leverage threatens the longevity of your capital by exposing your account to over leveraged positions. Successful risk management plan aims at preserving your initial trading capital.

Leverage and Lot Size

Leverage is the amount of a trading position you can control with a given amount of margin. The leverage ratio is the ratio of that amount of leverage to the amount of margin. A leverage ratio of 100:1 would mean that you can control $100,000 worth a position with just $1,000 on deposit as margin.

Retail traders have to understand this concept of leverage since they are usually required to trade on margin rather than credit.

This is where true risk management is important. Brokers in the industry tend to highlight the benefits of using high leverage. Traders with no risk management plan place large position in the market aiming for large profit. Instead, they lose all their money in the market.

Not every one of us has $10,000 or $5,000 to open an account with that is why you need to understand the risk of using such leveraged accounts and large lots when you trade with a small account.

You need to be as conservative as you can, at least at the beginning. Each trader has his own risk tolerance level that must stick with it.

By keeping a smaller lot size will allow you to stay flexible and manage your trades with logic rather than emotions.

Correlation and Risk Management

Another way to reducing your potential risk in the market is to include the power of correlation between currency pairs.

For example, if you go short on EURUSD and long on USDCAD, you are exposed two times to the USD, and in the same direction. It means that you are long 2 lots of USD. If the USD goes down, you have two losing positions with 2 lot size. Keeping your overall exposure under control will reduce your risk of a call margin.

Stop Loss and Trailing Stop

Risk management consists of learning how to control your losses. You have to know when to cut your losses as early as possible to preserve your capital. Traders should always trade with a proper stop loss. Once your stop loss is set on your trading platform, refrain from moving it farther as the market moves. By constantly changing your stop loss, you will ruin your account at the end of the day.

Stop Losses are your emergency exit, and should protect your account when your positions go wrong. If you set your stop too close to your price, or too far from your entry, it is going to get hit or get a margin call, and either way you lose money.

Traders can also use trailing stops to secure profits as the market moves in your favor. Trailing stops move your stops as the market moves farther away from your entry point. The stops will be triggered once the trend changes direction securing maximum profitability and protecting your account from potential losses.

Rules of Risk Management

·       If you lose trades consecutively, you can either lower your trading size by 50%, or take a break from trading. When you come back, you should trade smaller positions until you start winning again.

·       Only risk 1% of your capital per trade. You must avoid opening large positions to make up your losses.

·       Set and forget. Once you open a position, leave it. If you keep moving your stops, you are only increasing the risk of making wrong decisions.

·       Keep a trading journal as you trade. You can record details about your positions and the market conditions. Keeping a trading log will help you improve your trading skills and learn from your previous mistakes.

·       Stick to your strategy. You cannot change your plan just because you lost two or three trades. Losing trades is part of the equation, and by sticking to your strategy for a period of time you can then assess its reliability.

·       Do not take losses personally. It is not your fault the market is not moving in the desired direction. Instead, you need to adopt a neutral trading style.

·       Do not let losing trades run. Protect your capital from unnecessary losses. The sooner you cut your losses, the better you preserve your capital.

·       Do not jump on a trade just because you see the price moving down or up. Instead, wait for the market to retrace back and be prepared to enter at the right moment.

·       Never trade money that you cannot afford to lose. Always trade money that won't affect your daily life.

·       Always use a proper stop loss with your trades. Don't let the market swipe off all your balance. Stop loss will stop your positions from losing any further money from your account.

Reward-to-Risk Ratio

Another way to increase your profitability is to choose trades that offer a 3:1 reward-to-risk ratio. This means that you have the potential to make three times more than what you are risking. You can use this reward-to-risk ratio as a filter to help you cherry-pick trades with low risk and high reward.

Now, if you go short on EURUSD and you are risking 53 pips, you would need 166 pips as your reward. By doing this, your reward-to-risk would be near 3:1 ratio.

Keep in mind that this reward-to-risk ratio must be adjusted depending on your trading style, the market environment, and the time frame you are using. For example, a swing trader could have a reward-to-risk ratio of 9:1 while a scalper could be somewhere near 0.8:1.

Conclusion

Risk management is all about keeping your trades under control. Using proper risk management is what separate professional traders than gamblers. By avoiding risky behavior, you certainly increasing the probability of a steady growth of your capital.