The importance of risk management

Good risk management involves making trading decisions that help to mitigate potential exposure to losses by identifying, analysing and prioritising risks accordingly. Having a solid risk management plan is one of the most important aspects of successful trading.

In this article, we discuss the main risks involved in trading and provide some risk management tips and techniques you can employ in your CFD Trading.

Risks involved in CFD trading

There are several risks you should be aware of when trading CFDs, including but not limited to:

Market Risk

Market risk is the possibility of the overall market being impacted by a specific circumstance or set of circumstances. This may include financial recessions, geopolitical events, natural disasters or changes to interest or exchange rates. This can result in the decline of the entire equity market or a specific exchange/sector.

Volatility Risk

Volatility is a measure of how much an assets price changes in any given period. The more volatile a market, the more risk is created for traders, due to market uncertainty, a higher possibility for price swings and stop-outs.

Market gaps occur when there is so much volatility that the next quote received deviates significantly from the previous price. This can happen during times of important news releases or at the market open and closing moments. Price gaps can also occur during periods of volatility or low liquidity in the financial market.

During abnormal trading conditions, such as illiquidity or intense volatility, it may be impossible to execute your positions at the requested price and you could receive a significantly different price.

Liquidity risk

Liquidity is the ability to trade (buy and sell) an instrument and is considered good when there are many market participants interested in Buying and Selling the instrument at any volume. The easier it is to sell or buy the instrument at any given volume, the better the liquidity.

The more liquid an instrument, the tighter the spread usually, as the market participants compete to get the best prices. When there is low liquidity, the pricing is generally more erratic, and the spreads may be higher due to lower demand for the instrument. Extremely low liquidity in the relevant market may make it impossible to liquidate your position(s) promptly and could result in a loss due to the trade being executed at a price different than you expected or possibly even being unable to fill the order.

Leverage Risk

Leverage multiplies traders’ buying power, allowing investors to control a larger investment than their capital, potentially increasing their returns while only investing a percentage of the overall value of the asset in question. However, leverage is a double-edged sword, magnifying losses as well as gains. You can also incur losses faster with leveraged trading, so you need to assess how much risk you are willing to take. It is important to understand that using leverage not only magnifies potential profit or loss but also magnifies any costs associated with the trade.

This is because the spread or other cost as a percentage will have more of an impact on your overall account or margin amount. It is important not to over-leverage your account.

Learn more about leverage in our useful article.

Exchange rate risk

When an instrument or market you are exposed to is denominated in another currency, exchange rate fluctuations may have a negative effect on the floating profit/loss in the base currency of your account. For example if you are trading EURUSD in a GBP trading account, your PnL will be affected not only by the EURUSD rate but also the exchange rate of GBPUSD. Multiple external factors affect the exchange rates including geopolitical factors, economic data, natural disasters etc among others.

Risk Management Tips

Here are some basic risk management tips that will help you have more control over your trading and benefit your overall performance.

Consider your personal financial situation

Consider how much risk you can afford to take and whether you are in the financial situation to be able to bear significant losses, or even lose your entire investment, without effecting any of your compulsory financial obligations.

Determine your risk appetite & tolerance (your ability to lose, age, economic status, current financial situation, set financial goals & timelines) and use this as a base for your limit of trading losses per month/week/day. A suggested value is 1-2% per position.

You can use our online calculators to help you determine the funds required for each trade as well as pip values etc.

Manage funds with the FxPro Wallet

The FxPro Wallet is the hub of your account funding management and a valuable risk management tool. Funds stored in the wallet are not involved in the trading process therefore by keeping part of your money there, you are limiting your exposure to the market. Funds can be instantly transferred between Wallet and Trading Account(s) so you can choose to trade as much as you are willing to risk in each trading account, keeping the remainder safe in your FxPro Wallet.

Plan out your trading & document results

It is important to have a set plan for your trading goals. Going into a trade with no psychological preparation or price targets in mind is a recipe for disaster, and traders will often end up reacting on emotions alone. If you need to, practice your strategies first on a demo account to develop a solid trading plan.

While this may sound obvious, many traders overlook the importance of recording your trades and reviewing both winning and losing trades to identify any tweaks you need to make to your strategy. Know when you want to enter and exit a trade, what your targets are, and try to maintain a profit/loss ratio of 2:1. After all, it is not just the number of winning trades you make, but how much those trades profited compared to losing trades.

Determine position sizing and risk/reward ratio

Many expert traders suggest risking no more than 1%-2% of your balance on a specific trade. For example, a trader with an account of $8000, could use 800 to secure single trade. This prevents you from being over-exposed and leaves enough of a capital buffer for PnL.

The risk:reward ratio measures how much you expect in return based on your risk. For example, a 1:3 ratio would mean that for every $1 you risk, you can potentially make $3.

Utilise order protection

You can use stop loss and take profits order types to close potential loss or lock potential profit automatically:

-Stop Loss (SL) is an order that helps to limit losses and is set at a specific price level. If the price goes against you and touches the Stop Loss price, it will be triggered and the position will be closed.

-Take Profit (TP) is the order used to lock-in profits automatically when the price reaches a predetermined level.

You can close the trade manually at any time or wait until the Take Profit / Stop Loss level is triggered.

Many traders will use support/resistance levels, moving averages and pivot points to gauge sl/tp levels or use volatility indicators such as the ATR. As momentum changes, it may be necessary to adjust your stops accordingly to account for volatility swings.

A popular general method used by some traders is to set the Take Profit price twice as far from the open price level than compared to the Stop Loss price, however, there are many different methods out there for placing stops so it is ideal to do some research and determine what may work best for you according to the type of trader you are.

It is important to note, however, that using Stop-loss/Take Profit does not guarantee that your position will close at the specified price. Depending on the market movement, it is possible to receive positive or negative slippage:

Stop orders such as ‘stop loss’ are executed with ‘market execution’, meaning that once triggered, orders are executed at VWAP (Volume Weighted Average Price).

Limit orders such as ‘take profit’ are executed with ‘Limit Execution’, meaning that once triggered, orders are executed at the requested price, or better.

Pay attention to Fundamentals

Check major data releases to make more informed decisions according to the publications of important data and identify which economic events can impact the assets you trade.

Open the Economic Calendar on our website and filter news by impact (represented by exclamation marks). As soon as the actual statistic data publication is released, it immediately appears in the ‘Actual’ column. It also indicates the publication time, the name of the indicator, its description, the previous and predicted value.

In the run-up to and the aftermath of major news data or economic events, there may be very strong unpredictable movements on the affected currency pair(s) or assets.

Likewise, corporate actions (Dividends, Stock splits, Spins offs/mergers & Earning reports) may have a dramatic effect on the price of a share. Earning reports are often associated with increased volatility.

Manage your margin level

Pay attention to your account equity situation to avoid unexpected stop outs. A Stop Out is a forced automatic closing of position(s) in case a trading account balance falls below the margin close-out protection level.

The behaviour of the asset prices is difficult to predict, and therefore it is not recommended to leave positions open over the weekend if you want to avoid an unpredictable Stop Out caused by pricing gaps.

Actions you can take to prevent a stop out:
-Monitor margin level at all times
-Add more funds to increase your equity level
-Close out position(s)
-Don’t over-leverage
-Avoid trading market gaps

Diversification

We have all heard the phrase ‘don’t put all your eggs in one basket’ and this is an extremely important concept when it comes to trading and involves dividing capital across a range of asset classes and business sectors, to reduce exposure and risk associated with one asset/instrument The more diversified your trading, the less you may be dramatically affected by a strong market move in one economy or asset class. Diversification benefits increase when instruments have a negative correlation, and trades are held long term.

Constructive diversification means splitting capital within each asset class as well, for example within Share trading, to invest in different types of companies and sectors. Avoid large exposures to one currency, sector or asset class. Whilst diversification can help to reduce overall risk, it is important to note that doing so will not necessarily protect against losses, due to ‘Systematic’ (market) risk.

Diversification of trading systems

This involves trading with multiple strategies. This method will be most effective if systems are based on differing market properties. E.g., if you combine a "trending" system with a "flat" strategy.

Correlation of instruments

An important part of risk management is understanding the correlation between certain pairs. In general, pairs that share a common base or term currency will often have a positive correlation (for example EUR/USD and GBP/USD). In the case of a major currency being on opposing sides of the pair, (for example EUR/USD and USD/CHF), there is likely to be a negative correlation (i.e. chart movement is mirrored).

In the examples above, there is also a strong economic relationship between the GBP and EURO, and the CHF and EURO, which further strengthens the correlations of these currencies.

It is important to remember that there are of course times when correlation may not apply, such as when economic or political events have a different, or limited impact on similar currencies.

Hedging

Hedging is the common term referring to the trading technique of taking an opposing position in order to mitigate risks. In theory, as one position os losing, the opposing position will profit, thus offsetting some or all of the losses

Hedging can be used as a trading strategy, or to react to adverse market movements and mitigate losses.

Final thoughts

If you are new to trading, we would highly recommend going through our educational material and conducting your own research before using a risk-free demo account to practice and develop your trading strategy and risk management plan.