Risk Management

When you enter a trade, you accept a certain amount of risk . A simple definition of this risk is the maximum amount of money you could potentially lose should the trade not move in your favor.

Having an understanding of your own tolerance for risk will play a large part in determining the success you will enjoy in the market.

Do you know the exact amount of risk you accept for each trade?

Sounds like a simple question. Without knowing the answer to this question before you enter a trade means you could potentially lose your whole investment.

Risk management is a process by which the trader acknowledges the potential risk being adopted for the trade.

The importance of setting an acceptable amount of risk for each trade will help to protect your capital, allow you to calculate the most optimal position sizes and above all provide motivation to exit the trade should your risk setting be reached.

This motivation is important when trying to combat the negative effects of trading psychology.

Do you know when to exit a trade?

If you don't know when to exit a trade, your potential loss is undefined. Would you make an investment without knowing the amount of money you could potentially lose?

I didn't think so....

For this reason alone it's important to understand and accept an agreed amount of risk with each trade you take.

The peace of mind you will gain by knowing the exact amount of loss before you even enter the trade will be worth the effort of understanding money management.

Defining your risk can be as simple as a fixed percentage of your capital or a percentage of the entry price to a fixed dollar amount.

The way you define risk is totally up to you. Let's have a look at an example.

John has $50,000 in total to invest in the share market.

He decides that on any one trade he does no want to risk more than 1.5% of his total capital. He has settled on 1.5% as he is most comfortable living with this amount of risk.

John identifies a share and purchases 10,000 at $2.50. John has spent a total of $25,000 on this trade and has accepted a total of $750 risk for this trade.

John sets a stop loss at $2.42, this means he will sell all 10,000 shares should the price drop to $2.42.

Selling at this price would equate to a loss of $750.

In the above example, John pre-determined the amount of money he was willing to risk on any trade, before he entered it.

This is the basis of trade risk management. The first important step in this process is to understand you are taking a risk when entering the market and to pre-determine the amount of risk you are willing to accept.