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What is Risk Management and why it is important in trading?

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What is Risk Management and why it is important in trading?

Is your trading account suffering from losses? Do you get emotional during the trade and feel like giving up on trading? Well, in today’s article we are going to discuss the solutions to all these problems and also risk management techniques used by traders to protect their accounts and get steady returns.

You must have heard that 90 to 95 percent of people who trade in the markets end up on the losing side. This may happen due to many reasons, but the primary reason overshadowing all the other ones is very poor or no risk management. Often, traders fail to understand the importance and power of risk management techniques.

Generally, traders want excellent trading systems but they fail to recognize that an excellent trading system with poor risk management is of no use because every trading system has its pros and cons. You will come to know the importance of risk management as you read below…

“Plan the trade and trade the plan”

There are 3 main important aspects of trading-

  1. Trading system- trading system includes technical abilities of the trader such as price action, chart- reading, or whichever trading strategy you choose.
  2. Risk management- this includes risk per trade, position-sizing, stop loss planning and planning the profit levels.
  3. Trading psychology– trading psychology includes the mental aspect of trading such as emotion control, patience, etc.

These 3 aspects are interconnected in such a way that if one of them is missing, the other two eventually make no sense. For long-term success in trading, these are the three important qualities that are very essential.

Today we will discuss risk management which is the most important aspect among these three. Because if you are failing to manage your money then you will not have the right trading psychology and as we discussed earlier an excellent trading system with poor risk management technique is useless.

So, before starting to trade with real money you have to plan your trade by keeping these things in your mind.

Do not take the trade without planning a stop loss

Taking the trade without setting the stop loss is like driving the break failed vehicle on the highway. You will never know when there will be an accident. As a trader capital preservation must be your first goal then you can think about growing up your trading account. Remember, “rules of engagement 101 for trading”: NEVER leave your bank account unprotected when you go out to fight the “battle” of trading. Now the question remains, what does that mean to you as a trader and the most important question is how to apply it?

It means that you should not trade with your real money unless you have your detailed trading plan. Your trading plan must include various things like a maximum loss that you can bear, what is your risk per trade? Which signals can be taken as confirmation before entering into the trade? Of course, there are many more things which should be considered but these are the most important things among all.

Why is capital preservation important?

Usage of excessive leverage is considered a big risk in trading and it is the main reason behind the blowouts of trading accounts. Even the best traders can lose all their money due to excessive leverage.

Here the point we should understand is there are many good traders in the world some of them even get employed by major trading firms. However, not all of them can generate significant returns from trading because they fail in managing the risk of capital and capital preservation.

A “good trader” is not just someone who can analyze the charts and predict the next move of the market, but someone who can manage the risk of their capital with steady returns and can do this consistently with a trading edge. If you are lacking in your capital preservation skills then someday you will be ending up on the losing side. For long-term success in trading, you should practice capital preservation again and again.

The Process to be followed for making money as a trader-

  1. Limit all your losses up to the certain level which you are comfortable with losing on any trade.
  2. Try to develop a trading edge so that you will have bigger profits combined with smaller losses.
  3. Don’t try complicated things, remember only simple things work in the market.

How to implement risk management in trading?

  1. Risk to Reward ratio- it is the ratio of the total risk of your capital to potential reward on a single trade. If the risk-reward ratio is less than one then it doesn’t make any sense. Look for the trade which is having a risk-reward ratio greater than one. If you are getting a trade which is having a risk-reward ratio of less than one then leave that opportunity and wait for another one.
  1. Setting up the stop-loss- stop-loss placement is the key factor while planning your trade because it determines your position sizing and position sizing is nothing but how you control your risk.
  2. Position sizing- position sizing is nothing but determining how many lots or contracts you are trading during a single trade. It’s the distance between the stop-loss and entry point combined with the position size that decides the amount of money you are risking on a trade.
  3. Setting up the targets- You have to set the target levels logically. There are multiple ways by which you can place your targets like previous support and resistance, and daily market range, etc.
  4. Psychology of the trader while exiting the trade-Do not get emotionally attached with your positions, cut your losses at predetermined levels, and follow your trading plan.

Key takeaways-

  1. Do not take a trade without planning.
  2. More than your trading system and trading psychology risk management is important.
  3. Make sure to make capital preservation your primary goal while trading.
  4. Always follow your trading plan and develop a trading edge.

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