Effective Risk Management

Stones stacked on top of each other in front of a lakeEffective Risk Management

So you’ve been trading for months now, you’re generating revenue and have successfully managed to build up your trading portfolio with minimal CFD trading strategies. Sounds great doesn’t it?

But what if on one trading day, a spontaneous, unexpected event occurs and share prices crash, you haven’t implemented any stop loss orders, and your account is wiped out. Amid your devastation, you wonder where it all went wrong, how months of steady gains could be lost in just a single day. Unfortunately, though, this is the reality without utilising any risk management techniques.

Managing risk is one of the most critical aspects to your trading. Whilst it can often be overlooked, effectively managing your risk can really make or break your trading business.

Just as it’s a big risk to own a house without taking out building and contents insurance, so is trading without a risk management plan. In fact, risk management can be thought of as an insurance policy for your trading capital.

Read on to find out what you need to consider when developing a risk management plan.

1. Adopt a Trading Plan

Perhaps the most important aspect in your CFD trading strategies is the development of a well thought-out, all encompassing, trading plan. The importance of doing this has even warranted an entire article dedicated to it (see our 6 Essential Steps for Developing a Successful Trading Plan).

Developing a trading plan for your trading business allows you to remain cool, calm and collected especially when the market is moving quickly (which we all know is easier said than done). It will also provide you with a clear direction of how you want to invest and what you will do in different circumstances.

Amongst other information, your trading plan needs to include how you’ll evaluate your desired positions, an outline of your trading strategies, how you plan to handle stop-loss orders, how you’ll evaluate entry and exit points, at what point you’ll look to take profits, and of course, your risk management strategies.

Plan the trade, and trade the plan.

2. Implement Stop-Loss Orders 

A stop-loss order is used when a trader identifies the point at which they will sell their stock and take a loss on their trade. This is an excellent and highly effective method of reducing your potential risk and also prevents the “it will come back up” mentality.

Stop-loss orders are an excellent way to plan ahead whilst you are in a peak cognitive state and without external pressures influencing your decision. Successful traders know exactly what price they wish to purchase the instrument at and also at which point they’ve been proven wrong and need to bail out. That way the resulting returns can be measured against the probability of the share actually hitting their desired target and invest accordingly. In other words, the potential reward of the trade can be compared to the risk to see if the trade is a viable option.


3. Take-Profit Points

A take-profit point is the stage at which a trader will sell a stock and take their generated profit from the trade. This often comes into play when the potential upside of a trade is limited and will likely enter into a stage of consolidation after the large upward move has occurred.

Taking profit at a pre-determined price, whether it be partial or full profit, reduces the risk of an already profitable trade turning into a losing one. Successful traders will know ahead of time where they’ll likely take partial profits to reduce risk and also have pre-determined signals (detailed in their trading plan) that the trade has run out of steam, meaning full profits need to be taken.

Potential take-profit points can include, but are not limited to, previous areas of support (for short trades) or resistance (for long trades), price whole numbers (e.g $20, $5, $100), indications of a trend change (e.g breaks of significant lows or highs against the prevailing trend) and price extension away from moving averages.

4. Calculating Expected Returns

In order to effectively evaluate your trades and your potential profits, it is important the expected return is accurately calculated. The purpose of calculating expected returns is to compare trades so that only the most likely profitable ones are taken.

Calculating expected returns can be done by completing the following formula:

Returns = [(probability of gain) X (take profit % gain)] + [(probability of a loss) X (stop loss % loss)]

It’s a good idea to get into the habit of calculating your expected return and adopting this technique as part of your CFD trading strategies.


5. The 2% Rule

The 2 per cent rule is a basic tenant of risk management and should be a core aspect in your CFD trading strategies. It essentially means that you should never invest more than 2 per cent of your available capital on one single trade. To begin this process, you must first calculate what 2% of your capital actually is so you know the maximum amount that you should invest.

The necessary brokerage fees, commissions etc then also need to be calculated from the 2% of capital. The remaining funds once these fees have been calculated is the total amount that should be invested on one single trade.

Understandably, for those traders with smaller account sizes, 2% may be a less than desirable amount to invest with, however if the market turns upside down and doesn’t go in your favour, then the upside is that you are only exposed to a 2% loss.


CFD Trading Strategies: The Bottom Line 

Effectively implementing a thorough risk management plan is paramount to success in CFD trading. Adopting the above recommendations will not only help reduce your risk for the capital that you are currently trading, but it will also give you a foundation for determining how much capital to place on a single trade in the future.

It is of the greatest importance to calculate these accurately and only invest with the capital that you can afford to lose.

As it was famously said by Sun Tzu “Every battle is won before it is fought”. 


Become a master at reading the markets with our 3 part series:

Reading the Market Part 1: Understanding General Price Action Trading
Reading the Market Part 2: Short Term Price Action Strategies
Reading the Market Part 3: Understanding Trend Trading