Trading risk management is essential to your success long term no matter what type of trader that you are. It’s important that you don’t over trade and cut your losses when a trade goes against you. Let your winners run. Always shoot for at least a 1:2 risk/reward ratio, ideally 1:5. That means you risk $1 for the potential to make $5.
What is Trading Risk Management?
- What is trading risk management? Trading risk management is often overlooked but essential in trading. It’s when a trader figures out the potential loss on a trade and then take action or sometimes inaction. If you learn that you have the ability to lose more than you’d make on a trade, you want to stay out. It’s especially important when you trade penny stocks.
It doesn’t matter how good of a trader you are; one bad trade and you could lose everything.
Hence the importance of protecting your capital. You’re never going to make successful trades 100% of the time. Even the best traders in the world fail 30-40% of the time.
The difference between new traders and seasoned traders is the ability to limit risk. When starting out, you soon learn that trading is emotional.
If you let emotions rule your trading, you’re not going to last very long.
Limitation is Key
There’s no removing risk in trading. You’re always going to be taking risks no matter what. Limiting risk is the key to being successful.
The stock market is a war between buyers and sellers. When you place a trade, you’re entering that battle. Hence trading risk management is a lot like plotting your strategy.
Wars are won by having a winning strategy. If you go in willy nilly, you’ll never achieve anything. It’s the same thing with trading. Managing risk is something that’s talked about a lot.
However, it’s not always followed. That may be a large part of why 90% of traders quit. You need to learn basics of the stock market and trading risk management as well as apply them.
Sometimes the most simple steps are often the most overlooked steps.
Plan Ahead: Trading Risk Management
Part of trading risk management is to plan your trades ahead of time. Planning your trades before you take them can be the difference between success and failure (check out a list of the best brokerage firms).
You plan your trade and trade your plan. You’ll find that when you deviate from your plan, it’s often not a success. Why? You’re letting emotion control your decisions.
I always want to risk less than I can potentially make. Meaning I will look for a 2:1 at MINIMUM risk reward ratio. So if I can make a dollar, I will only risk 50 cents. USUALLY I look for 3, 4, all the way to 10:1 ratios. Meaning I can allow myself to risk 1 dollar, and can potentially make TEN dollars on the trade (per share).
Any good trader knows the price he or she is willing to pay ahead of time as well as what price they’re willing to sell at. They have to look at the charts to see the probability of the stock hitting their desired price.
When the return is in fact high enough, then place the trade. Hence the importance of knowing how to read patterns and know what candlesticks mean.
Trading risk management doesn’t happen without candlesticks, patterns and your willingness to look at profit and loss. Take a look at unsuccessful traders. What do they have in common?
They enter trades without figuring out their profit and loss targets. They have no idea when they’ll sell. This causes emotions to take over. When emotion is dictating trades, you’re on your way to blowing up your brokerage account; especially if you’re trading both stocks and options (bookmark our penny stocks list and stock watch lists pages).
How Much Should You Risk on Each Trade?
- How much should you risk on each trade? There isn’t a hard rule, however, a good guide is 1:5 ratio. An example is to risk $0.10 for the potential to make $0.50. Or risk $1 for the potential to make $5. There isn’t a hard rule but never risk too much in your account.
Stop losses are one way to help with trading risk management. Setting a stop loss sets a price when you’ll sell a trade taking a loss. If you’re only willing to risk 10 cents on a trade, you set your stop less 10 cents below your entry.
The more you practice trading, the better you become. Then you get to a point where you don’t have to make a stop loss order. You can set mental stops for yourself and not tip off market markers.
A stop loss gets rid of the it’s going to reverse mentality. That kind of thinking is emotional. You can’t go about trading risk management while letting emotions dictate everything.
When stop losses are used correctly, you can minimize the number of trades because you’re not needlessly getting in and out of trades. This helps cut down on commission fees and helps if you’re limited in the amount of trades you’re allowed.
Setting your stop losses can depend on whether you’re bullish 0r bearish on stocks. Again knowing whether to take a bullish or bearish position on a trade is all about being able to read charts and patterns.
Support and Resistance
Support and resistance plays a huge role in trading risk management. If you can’t find support and resistance, you’re not going to be a good trader.
Those levels are how many traders find their profit and loss ratios. You’re always hearing “buy at support, sell at resistance.” If you’re shorting than you sell at resistance and buy at support.
Support levels are great for setting a stop loss. Meanwhile, resistance is a great profit target. Many of the great trades are closing their positions when it reaches resistance levels.
The importance of support and resistance can’t be stressed enough. Those levels can help to rationalize trades. If a stock is too close to resistance, then you wait to take the trade (try our stock picks service free).
Bottom Line: Trading Risk Management
Trading risk management means you’ve planed the trade before you execute it. Stick to your trading plan. It keeps emotions from clouding your judgement. A successful trader is methodical in their approach. Emotional traders don’t last. Take our free online trading course.