Effective Strategies for Managing Risk in Trading

Profiting from trading requires knowing how and when to cut losses. Without risk management skills, profits are simply on loan from the market, and all you can do is hope to sell high before the next big drop. Asset prices are often volatile and may fluctuate more drastically and faster than expected. To avoid suffering losses, here are a few strategies for controlling risk using data analysis and forecasting.

Techniques for Managing Trading Risks

There are risk management tools that most people aren’t using, or even aware of. These include predictive tools, trend analysis, risk calculators, movement analysis, account capital management, and correlation tools. For starters, consider the following risk management tools for every trade.

A stop loss is the exit point for a losing trade. It is commonly placed at a point where the trade idea or the timing of the trade idea is proven wrong. It could be based on a technical indicator or price action. 

The following chart shows an example of how a stop loss could be used to limit risk and, at the same time, create a very attractive risk/reward opportunity (where the potential profit is much larger than the potential loss).

 

Another essential risk management tool is a position size calculator. It calculates the maximum amount of investment you can risk based on desired parameters. Most professional investors don’t risk more than 2% of their account on a single trade. If you are a regular trader, risk 1% or less to protect your capital. 

Here’s how to calculate position size using this tool.
 

• Calculate 1% of the account balance. Example: 1% of a $10,000 account is $100. Therefore, $100 can be risked per trade. Call this “account risk.”

   

• Divide the account risk by the difference in price between the entry and stop loss price. Example: enter a stock at $50 with a stop loss at $48. The difference is $2. This is called the “trade risk.” Therefore, $100 / $2 = 50. This trader could purchase 50 shares. 

  • If trading forex or futures, multiply the tick or pip value by the difference between the entry and stop loss. Position Size = Account Risk / (Trade Risk * Pip Value)
     

• 50 shares x $50 entry = $2,500. The position costs $2,500 to initiate, yet if the stop loss is hit, only $100 will be lost. 

A Guide to Analyzing Risks in Trading

Beyond stop losses and position sizing, there are additional tools and tactics traders use to analyze and manage risk in stocks, forex, futures, options, and crypto trading. These tools include trend analysis, predictive or statistical tools, risk calculators, deposit management, correlation awareness, and profit analytics. Let’s look at each of these in depth.

1. Build a Risk Management Strategy Around Market Trends

You can use trends to manage risk. While all trends eventually reverse, some can persist for long periods and cover a large price area, helping offset losses during choppy conditions. 

Here are a couple of ways traders use trends. 

• When the price is potentially breaking out, the trader initiates a position and holds the trade if a new trend develops. The large profits from trends offset the losses from false breakouts. Such a strategy may rarely work, but when it does, the profits easily cover all the losses. 
   
• As trends unfold, trades follow their direction for profits anywhere between two to five times the risk, sometimes even more. This is a more in-and-out approach than the one above. The win rate tends to be higher as profits are locked in more often and the trend is already underway, but the reward relative to the risk on the typical trade is smaller.

In either case, you can use the trend to your advantage. Remember to have an exit plan for losses and exit profitable trades if the risk is higher than your average.

 

2. Risk Control With Predictive Tools

Predictive tools provide statistics based on historical market scenarios. A simple example of a predictive tool is seasonality. July is historically one of the best months of the year for the US stock market, while September is often the worst. 
Traders can leverage this data by focusing on long stock trades in July and potentially sitting out in September. Use the market trend tools from the previous section to further enhance risk management. 

Chart patterns, such as head and shoulders and rounded tops/bottoms, have also been statistically analyzed. This provides a predictive model for how often the patterns work and how far the price tends to move after completing the pattern.
 

3. Calculating Risk With Stock Risk Calculators

One of the simplest risk calculators is an indicator called Average True Range (ATR). It tells traders how much an asset moves over a given time frame. For example, if the daily ATR is 1, the stock moves $1 per day on average. This can be useful for managing risk. 

If trading a daily chart, expect about $1 of daily movement, although this value will fluctuate over time. Consider placing stop losses outside the typical ATR while trading. A $1 stop loss in this case could be easily hit by a normal day’s movement. A $2 stop loss would require the price to move about 2 full days' worth of movement to hit the stop loss. 

4. Financial Exposure With Deposit Management

How much capital is put into the account can be an effective risk management measure. Of course, the budget varies from trader to trader, but here are the basic rules of how to use deposits to manage risk. 

• If taking large losses is not an issue, deposit all the trading capital into the account. Ideally, the account balance should be 100 times the desired risk amount per trade. If a trader wants to risk $100 per trade (to make $200 or more per trade, for example), the account balance should be at least $10,000. This assures each trade can have proper position sizing while factoring in personal goals. 
   
• New traders, or traders that tend to “go on tilt” or have large drawdowns in the account, may wish to only deposit a portion of their actual trading funds. Previously described risk control tactics still apply. But if the trader experiences a large drawdown, they still have some safe capital to correct their approach and try again. This helps preserve capital during the learning stages.

5. Manage Forex Risks With Correlation Statistics

Many currency pairs on forex are highly correlated, which poses a hidden risk. A trader may see a long set-up in the EUR/USD, so they take it. Then they see another one in the GBP/USD or USD/CHF and take it as well. While these trades may seem independent, they will likely lose or win together, as they are often correlated. 

If risking 1% per trade, the trader could win them all, but it is also possible they could lose on them all since the pairs move similarly. 

For example, at the time of writing, GBP/USD shares a 0.94 correlation with EUR/USD, and USD/CHF shares a -0.96 correlation with EUR/USD (very similar movement, but in the opposite direction).
 

 

Monitor currency correlations. If pairs are highly correlated, pick the highest quality trade based on careful analysis. Or, if you’re feeling risky, make multiple ones. In this case, equally split the typical position size between them.

6. Using the Options Calculator for Profit Analysis

When you buy an option, the trade risk is capped at the option’s premium price. The strike price and the time to expiry are key factors in assessing how profitable the trade may become, and how the underlying asset price moves until expiry. 

While some option calculators may provide theoretical profits, consider using the tools mentioned earlier. They will help you predict how far prices run after breaking out of a chart. 

If a stock is trading at $200 and breaking out of a chart pattern that tends to run 10% (or more) in about two months, and a two-month stock option with a $200 strike costs $6 per share, there is a $14/share potential profit there. 

The risk is capped at $6 per option contract. However, if the stock price does move up to $220, the option will be worth approximately $20 near expiry ($220 stock price - $200 strike). $6 was paid for the option, netting a nice profit. One option contract will cost $600, for a potential profit of $1400, like in this example. 
 

 

To risk $600 on a trade, the account should be at least $30,000 or more ($600 is 2% of that) based on position sizing risk management. 

Explore New Strategies for Improved Risk Control

Consider using additional tools such as daily or monthly loss limits. Also, limit your trading depending on daily physical or mental capacity, such as reducing position sizes if not feeling well or feeling highly aggressive or timid. An unstable mental state makes you more likely to make mistakes. 

Hedging can be a risk management strategy, as can trailing stop losses. Review trades regularly. Actively look for ways to reduce risk on trades, improve entries, or squeeze more profit from winning trades.