Risk and reward can co-exist alongside each other. The enabler? A risk management plan. In trading, where risk and reward are positively correlated to each other, having a sound plan to mitigate the former is crucial.
More than ensuring one doesn’t find themselves in financial distress upon trading, having a risk management plan is crucial for the mental well-being of a trader too.
As Chinese military general Sun Tzu’s famously said: “Every battle is won before it is fought.” The best traders often plan the trade and trade the plan.
In this article, we will discover the keys to building a robust risk management plan, the difficulties faced when executing it and how technology can aid in solving these problems.
First, make diversity your best friend. Majority of traders follow the one-per cent rule. This rule of thumb recommends traders to never put more than one per cent of their trading capital into a trade. For example, a trader with $100,000 in their trading account are not recommended to hold any trade position exceeding $1000- % 3000 (1 to 3% of capital).
By doing so, one avoids over hedging on a single trade and spreads the risk across multiple assets and instruments.
Additionally, one should look to set stop losses on each trade they enter. Using moving averages as a gauge, traders should set a price point where they will exit a trade.
A piece of advice often shared by professionals is to utilise longer-term moving averages for more volatile positions to reduce instances where large price swings will trigger the stop loss.
To reinforce your risk management plan, you should look to back-test your trading strategies. This refers to testing it on past data to see how it performs over time.
It is advised to back-test over a long time period encompassing different types of market conditions to ensure that your strategy is sufficiently robust to withstand the highs and lows of the market.
However, executing a risk management plan is easier said than done. The primary cause of this challenge lies within us. Emotions are a trader’s worst friend.
When caught in a spiralling downtrend of a stock price, emotional traders are steadfast in their belief the stock would recover as they “like” the stock.
Such baseless assumptions only serve to increase the risk and result in greater losses. When we uncover these emotions further, we will discover that they are driven by our fixation on profits. This is especially so for professional traders whose livelihoods depend on the execution of profitable trades. This additional stress only serves to further impede our decision-making skills and result in riskier trades.
Apart from emotions, executing a good risk management plan requires time and effort. To back-test strategies and constantly adjust stop losses is a luxury many retail traders do not have the time to afford.
As with other resource-intensive tasks, the solution lies in automation. One such method is through systematic trading. By letting algorithmic programmes instead of humans execute the trade, emotions are taken out of the equation and reduce trading risk.
Snap Innovations (www.snapinnovations.com) offers advanced algorithmic trading systems to aid traders in reducing trading risks. With programmes that scan and execute trades with incredible speed, traders can seize low-risk opportunities in an instance.
Traders can also utilise AI trading bots to automate the risk management processes shared previously. With AI bots provided by SnapBots (www.snapbots.io), traders will not need to constantly monitor positions and worry about the unnecessary triggering of stop losses.
In summary, one should never enter a trade without knowing the exit plan. By adopting the risk management methods shared above, you can significantly reduce the risk of trading to minimise losses and maximise gains. For the adage of “fail to plan, plan to fail” stands true.
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