TAKE YOUR EMOTION OUT OF TRADING BY MANAGING RISK

 
David Morris
FX360

LAST week, I began a series of three articles aimed at anyone who is considering trading for themselves. My own background is in spread betting and contracts for difference (CFDs) and, over the years, I’ve managed to pick up a few do’s and don’ts. But before launching in, it’s important to emphasise a particular point: trading is speculation, making it fundamentally different from investing.

Trading through spread bets and CFDs is done on margin. This means that you can gain significant exposure to an underlying financial instrument with a relatively small amount of money. This magnifies the potential for profits, but also brings significant risks. Trading on margin therefore requires a particular mental attitude and plenty of discipline. In my world of spread betting and CFDs, trading on margin is one of the major attractions. But it also has a downside. If markets move against you, you can lose more than your initial deposit. Consequently, the most important first step for anyone considering trading using a margined product is to understand completely the potential for losses. For this reason, I should remind everyone, never trade with money that you cannot afford to lose.

Before making a trade, it is vital to address money and risk management. These two connected elements are the foundation to a successful trading career. Proper money and risk management won’t make you a better trader. But setting down a framework, organising your risk capital, and planning your trades in a disciplined fashion, puts you in control. This is vitally important when trading in fast-moving – and often seemingly illogical – financial markets.

So, once you have decided how much of your capital you are prepared to risk, the next step is to manage it properly. By this I mean dividing it up into tranches. How you do this is an individual matter, and will depend to a great extent on the markets you intend to trade and the type of trader you are. For instance, are you more suited to day or longer-term trading? Do you intend to focus on currency pairs – which typically have a low initial margin requirement – or individual stocks, where initial margins are typically higher? Advice on this matter is varied. Many traders will say that you should never risk more than 2 per cent of your risk capital on any one trade. Others will argue for a lower percentage. Some say it can be more. But let’s say that you open an account with £5,000. Using the 2 per cent rule allows you £100 per trade. This will limit what you can trade, but will give you the opportunity to trade fifty times, even if all unsuccessful. At the other extreme, using 10 per cent of your risk capital per trade should give you ten opportunities. But £500 per trade will widen the list of financial products available to you.

Risk management comes next. Most professional traders are happy if they make money on 50 per cent of their trades, as they employ disciplined risk management techniques. These ensure that they make more money on their successful trades than they lose on their failures. This helps them to make money over time, as they consistently win more than they lose. They do this by constructing a trading plan. Before they place a trade, they have a clear idea of how much risk capital they will assign to it, where they are looking to enter the trade, their first profit target, and where they will put their stop-loss in case the trade idea doesn’t work out. Creating a plan like this helps to take the emotion out of trading. It also ensures that you never enter a trade if the potential risk-reward ratio is too low – in other words, risking £100 to make £50, rather than £150.

Next week I’ll look at the differences between day and longer-term trading. I’ll also consider trading psychology and how important your attitude is in dealing with losses, and profits.