Risk Management Strategies For Advanced Traders
Financial markets trading is a very lucrative venture but comes with significant risk. Learning how to manage risks is vital to becoming a successful trader. In this guide, we will look at everything you need to know about risk management strategies for advanced traders. Beginners can also apply these strategies to their trading. If you are a binary options trader, check out risk management techniques for binary options trading.
A risk management strategy refers to an outlined plan on how you will deal with trading risks, preemptively and as they occur. Advanced traders have several risk management strategies that they can apply to their trading strategies. We will discuss these approaches under three subheadings:
- Budgeting
- Diversification, and
- hedging.
Budgeting
There are many budget-based approaches to managing trading risks. These include position sizing, profit-loss ratio, and price targets. You can combine these approaches as part of your risk management techniques.
Position Sizing
Position sizing means determining the percentage of your trading capital to allocate to a single position. Position sizing can help build discipline and minimize losses.
The exact percentage you use depends on your risk tolerance, but many successful traders swear by the 1% rule. The 1% rule says the size of a position should never exceed 1% of the total capital.
Traders with higher risk tolerance might invest a higher percentage of their capital in each trade to boost potential profits. This approach, however, also increases potential losses.
Profit-loss ratio
The profit-loss ratio gives you a good idea of how much profit you can expect from your closed pistons. Note that the profit-loss (P/L) ratio is only an estimate based on statistical probability. The profitability of your positions depends on the actual profits or losses you earn from each position. Understanding the P/L ratio will allow you to know how many trades you should expect to make.
To calculate your P/L ratio, you must know your reward/risk ratio (RRR). For example, a 1:1 RRR implies that you need a 50% win rate for your positions to break even.
Price Targets
Knowing when to enter and exit a trade is one of the most fundamental risk control strategies. Many technical indicators can help you determine the best time to enter and exit a trade. Some of these indicators are:
- Support and resistance levels
- Moving averages
- Average true range
You can use take profit and stop loss orders to automatically exit a trade when you hit your profit levels or lowest acceptable losses.
Diversification
The advice of “not keeping all eggs in one basket” also applies to trading risk management. Deiversitifiavation means spreading your investment across less-correlated assets. As such, if a factor negatively affects one asset, your investment in the other asset will remain stable.
When it comes to portfolio diversification, you have three options:
- Positively correlated assets: These assets move in the same direction. So when the market moves in favor of one asset, you can expect the other set to experience a significant bump in price. Examples are cryptocurrency assets.
- Negatively correlated assets: These assets move in opposite directions. Profit in one asset will trigger a loss in the other asset. Examples are currency pairs such as USD/JPY.
- No or low correlation assets: These assets have no price relation. As such, profits or losses in one market do not affect the other. For instance, commodities and cryptocurrency assets have a low correlation.
The types of assets you have in your portion will depend on your trading strategy and risk tolerance. However, some assets in your portfolio should have low correlation so a single market event doesn’t wipe out your investment.
Hedging
Hedging is a risk management technique in which you open a trading position on a sheet in one direction and another on the same asset in the opposite direction. If you lose your primary position, the profit from the alternative position will make up for your loss.
You can apply hedging on all your trades or use it selectively on positions with potential loss. If you use hedging uniformly on your position, you must observe the market. When the market favors your primary position, you must exit your alternative position and vice versa.
On the other hand, you may only hedge positions when the market conditions give you cause to worry. Traders typically use this approach to protect their trading funds when a sudden market downturn occurs.
Conclusion
This article discusses the three primary risk management approaches advanced traders use (budgeting, diversification and hedging). When combined with a sound trading strategy, these risk management methods can help improve the preservation of your trading capital, increase your profits and minimize your losses. You can further research the best risk management strategies for trading binary options.