Risk management in trading or investing is perhaps one of the most important factors in determining the success or failure of a trader, although it is undoubtedly one of the most neglected factors. As Warren Buffett, president of Berkshire Hathaway and possibly the best investor in history, says, “Rule number 1 is never losing money and second, never forget rule number one”. If one of the richest people in the world says this, we must be aware of the importance of proper and systematic risk management in investments. Not in vain, a few wrong or poorly executed market trades can put an end to all or part of our trading account.
Managing risk is not something for which there are exact and simple rules, since it is something totally variable depending on the type of investor we are. In this way, a trader who prefers intraday trading will not assume the same risk in each transaction as a “value investor” whose time horizon is months or years. In the case of the latter they are able to withstand large temporary losses (in some cases higher than 50%) as well as averaging down, aspects that a professional trader can not and should not afford at any time.
As we have just said, there are no generic rules for risk managing, but generally, and more specifically for short-term traders, it is estimated that they should not risk more than 1 or 2% of their capital in each transaction, since a higher risk per transaction would be unwise and could lead to a significant loss of your assets. In addition to this rule of monetary risk management, most traders use the classic “stop loss” orders that limit their losses should the market turn against them. Regarding the latter, it should be noted that the ideal is to automate it and not apply mental stop loss, since we run the risk of not applying it in the appropriate way (there are many psychological biases that prevent us from closing a losing position and closing a position with benefits).
CFD Risk management tools
Therefore, in order to avoid this type of psychological bias and misconduct, some brokers like Avatrade has designed a series of professional risk management tools that are very simple to use and that will make our life easier to manage our trading portfolio.
The first tool provided by brokers like Avatrade is the “stop loss“, which we talked about earlier. As we have said, it is used to limit losses in case the market change its direction against us. The operator sets the maximum amount he is willing to lose in a given trade and when the set loss threshold is reached, the position is automatically closed.
The second tool for CFD risk management is known as “Take profit“. It is an order that basically consists of the opposite of the “stop loss” order, that is, it is used to close a position with profits when the market moves in our favor. The trader establishes in advance the price at which he wants to close the position and when the market reaches that price, the previously established order is executed. This type of order, although it may seem strange, is very useful, since it prevents us from turning a winning trade into a loser. In many cases greed causes the investor to keep his positions open because he wants more and more money in moments when he should close all open trades and consolidate the accumulated profits. If we use these types of orders, we will ensure that the capital gains are maintained.
The third tool is the so-called “entry limit“, which basically consists of entering the market at a more favorable price than the current one. These types of orders are especially useful when trading with Contracts For Diference in the Forex market, in which the price spreads may not be favorable to our interests at certain times.
The fourth and last tool offered by some brokers, and not for this the least important, is known as “entry stop“. This order consists of entering the market at a more unfavorable price than the current price and, therefore, is issued above the current quotation price of the asset in question.
As we have been able to verify, CFD brokers offer four simple but very tremendously useful tools for risk management in our daily transactions. Most traders think that they are able to manage the risks inherent in the financial markets themselves adequately, but it is more than proven that this is not the case, so a proper use of these tools is decisive if we want to be winning and consistent traders.