Top Risk Management Techniques for New Traders

Bruno Iksil, nicknamed the “London Whale,” took a large position in the credit default swaps market in 2012, costing JPMorgan Chase $9 billion. Known for his risky trades, Iksil did not adequately consider the risk due to the ongoing European “balance-of-payments” crisis since 2010. Notably, he took the position as a “hedging strategy” for the bank. Unfortunately, the hedge was too big and wrongly placed. JPMorgan could absorb the loss (and associated fines) because it had a $1 trillion balance sheet at the time.

Richard S. Fuld, Jr. (ex-CEO of Lehman Brothers) said, “The key to risk management is never putting yourself in a position where you cannot live to fight another day.” These are good lessons for even a beginner trader. Adopting stringent risk management techniques to trade within your risk limits helps optimise earning potential. This article discusses some of the most popular risk management techniques for forex trading.

Types of Risk

You must understand the types of trading risks to gauge your risk exposure and apply appropriate techniques to mitigate it:

Market Risk

The most common type of risk is the potential for the market to move against your speculation. This can happen if factors you had previously taken into consideration change abruptly. For example, an economic data release goes against prediction, or unexpected geo-political event occurs.

While you cannot predict all possible events, conducting comprehensive market research is critical for active traders. Learning deeply about the instrument and the factors that move it is essential. Additionally, invest in learning the most suitable technical analysis methods for different situations to gauge market risk adequately.

Liquidity Risk

Liquidity risk arises due to insufficient trading interest in an instrument. The poor volume of trades increases the difficulty of buying or selling an asset at favourable prices.

While the best way to ensure liquidity is to trade the most popular instruments, it may seem restrictive and counterintuitive for some traders. The alternative is to look for the most suitable times of the day for higher liquidity. For instance, the EUR/USD is the most traded forex pair. Overall, forex trading volume is the highest when the trading hours of the London-Tokyo or New York-London markets overlap. Trading a forex pair during these overlapping hours is a smart way to gain exposure to greater liquidity. Finally, choose a brokerage with deep order books so that they can route your orders fast to reduce the chance of slippage.

Operational Risk

This is the most difficult risk to identify, even in retrospect. It includes factors such as a power failure, delay in trade execution, etc. Internal or external system failures are usually impossible to predict.

The best way to prevent operational risks is to choose a reliable broker with a cutting-edge and stable technology stack. Also, choose a reliable internet connection provider. Additionally, trade when you are mentally alert and can swiftly make recovery decisions if the unforeseeable occurs. 

Individual Risk

Now, this one is completely on you. Ensuring that your decisions are not driven by emotions, such as fear, greed, anger, or euphoria, is critical. Being under stress, in a hurry, or cognitively absent can hamper your decision-making. It can prevent you from assessing the risk adequately and taking appropriate measures. 

The good news is that personal risk is completely in your control. The best way to manage personal risk is by building emotional discipline. Start by developing a trading psyche and practice assessing your emotional state before taking a position, identify your weaknesses, and avoid trading when emotions run high.

Top 3 Market Risk Management Techniques for Beginners

Risk management is all about correctly sizing and timing your positions to reduce exposure to unfavourable market movements. Active risk management techniques help mitigate market risk. It has the highest possibility and is significantly more apparent than other types of risks. Here are the top risk management techniques for this.

1. Diversify

A diversified portfolio has a balance of uncorrelated and negatively correlated assets. This spreads the risk and enhances the potential for positive returns. For instance, during the COVID-19 pandemic, the aviation industry went into a slump while the IT industry flourished. The two are uncorrelated industries.

Diversification can also occur in other ways. For instance, while trading forex with CFDs, traders can hedge a long position in a forex pair with a short position in the same pair. Trading in both directions is a benefit only derivative instruments provide. 

2. Follow the 1% Rule

The 1% rule helps you determine the amount of capital to put at stake with a single position. This rule states that the risk associated with a position should not be more than 1% of the portfolio’s total value. However, experienced traders may take up to 2% of risk with each position. 

3. Exit Points

Setting exit points is a practice every trader must master to the extent that it becomes natural. Exit points, such as stop loss, trailing stop loss and take profit, let you automate position closure when the price reaches a certain level.

Stop loss ensures that your position closes at a fixed value or a percentage change if the market moves in the opposite direction. Take profit, on the other hand, is a way to lock in profits when the market is favourable. This prevents you from losing your gains in case the market reverses suddenly after a winning move. 

Risk management is critical for satisfying trading experiences. Watch this space to learn more about improving trading experiences as a beginner.

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