Every aspect of this world has its own risks and rewards, and financial markets are no exception. Interestingly, financial risks and financial rewards share a very close bond, and our success in financial markets depends on our ability to keep them apart!
Mastering this ability is key to becoming a successful trader; to be able to maximize our profits while pushing the risks down to the lowest level possible. To achieve this, successful traders choose their trades carefully, apply proper risk management techniques, and learn from their mistakes.
In this article, we’re going to talk about some of the common risk management techniques you can use as you progress through your trading journey.
Whether you’re in a losing bet or a winning trade, you should always know where to stop. A stop-loss order limits your potential loss, while a take-profit order ensures that you realize the desired profits. Let’s see how they work:
You want to buy Bitcoin at $30k as you believe it’ll appreciate in value in the near future. But things don’t always go according to plan, especially when it comes to the crypto market. To minimize your loss in case of a market crash, you place a stop-loss order at $27k. By using a simple order, you’ll limit your potential loss to 10% of your investment.
Let’s say based on your analysis, you expect the price to rise to $36k before starting to fall again. So, you decide to place a take-profit order at $36k to make sure your bitcoins are sold at the desired price and your 20% profit is realized.
In most trading platforms, you can set your stop-loss and take-profit in the same order you place to buy the asset.
Not every trade is a good trade; Always analyze your trades beforehand by calculating the Risk/Reward Ratio: you’d be amazed how much time and trouble a simple calculation can save you!
With the Risk/Reward Ratio (R/R), you can compare the potential profit with the potential loss and see if the trade is worth a try. Let’s calculate the R/R ratio for our trading example:
First, we need to calculate the difference between our stop-loss and take-profit and the entry price. We already know that our stop-loss is 10% lower than our entry point. Based on our analysis, $36k is a good place to take profit, which translates to 20% profits.
Our Risk/Reward ratio will be 10:20 or 1:2, which simply means we can double our investment by risking just half of that amount.
Position sizing refers to the amount of money you’re willing to risk in a single trade or investment. The 2% Rule can be quite useful here. Simply put, you never risk more than 2% of your investment capital in just one trade.
Now, let’s see how we can calculate the position size based on this rule:
Let’s assume that you have a $50k account. Based on the 2% rule, you cannot risk more than $1000 in just a single trade. Now, in our previous example, the stop-loss was 10% below the entry point which means we risk losing $3k dollars for each Bitcoin we buy.
To calculate the position size, we need to divide the 2% risk of the capital by the trading risk. The position size for this trade would be 0.33 Bitcoin or $10k.
Fear and Greed are the main emotions you may experience while trading. In a bull market, where the prices are rising at a growing pace, you may feel the urge to invest more than what your trading strategy indicates you to. Similarly, a bear market may drive you to panic selling without considering your plans.
The best way to avoid irrational actions like this is to always stick to your trading strategy which you had planned thoroughly beforehand based on your risk tolerance and market analysis.
Diversification helps you to minimize your risk exposure by distributing your investment capital across various asset classes and markets. Diversification is a smart risk management technique that helps you avoid huge losses due to a single asset or market crash.
If you’re interested to learn more about diversification, read our article to see how you can benefit from a diversified portfolio and how much DIFX can help you in this regard.