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Three Essential Elements of Risk Management

Three Essential Elements of Risk Management
August 06
19:37 2012

Losing money is a natural part of day trading. Even during a profitable trading day there will be some winning trades and some losing trades. The key to success is learning to apply risk management to reduce the exposure to and impact of the losing trades. All day traders must have a risk management strategy before they can become profitable. The nature of uncertainty in the market requires this. There are three essential elements of risk management that are described in this article.

Avoid trades that have high probability of failing

Trading is all about probabilities. Traders make decisions and execute trades based on what they believe to be the probability of the trade working or failing. Good risk management strategy requires that traders understand when the market is most likely to produce trading signals that have a high probability of failing. There are three scenarios when the market is most likely to fail.

The first is around the release of news. News, or rumor, creates uncertainty as the market makers and other major players react and then place their bets. The market can be very volatile during these moments and will break every rule of logic. It is best to be flat when news is being released.

The second scenario is when traders attempt to trade against the trend. This is very tempting to do especially in a highly volatile market where the pullbacks in the price can be pretty substantial. However, when the market has taken a clear direction it is much easier to follow. When trading against the trend there is a really high chance that the market will not follow through in the counter-trend trade.

The third scenario is when the market has no trend. Without a direction the choppy, sideways movement of the market is unpredictable and can be very costly. During this churning stage it is best that traders keep their money out of the market and wait for it to take a direction.

Always watch the bottom line

The bottom line in risk management is protecting the money in the trading account. Once the account is drawn down past a certain point margin requirements may be triggered and traders will not be able to execute any more trades. Being able to cut the losing trades is the most fundamental aspect of risk management. Without this ability, traders will never reach profitability.

To succeed at this, traders should set daily limits on how much they will allow themselves to lose before they stop trading for the day. By using daily limits traders can guarantee that they can stay in the market for a longer period of time. Traders should also set limits on how much they will allow themselves to lose on any particular trade. The loss should be in proportion to the expected gain. It makes absolutely no sense to allow a trade to lose twice as much as there was a potential gain.

Minimize the use of leverage

Leverage is a double-edged sword; it can allow traders to reap huge profits but can also lead to inflated losses. Sometimes traders practice the strategy of “double up to catch up.” Although it makes logical sense, this often doesn’t make financial sense. When traders are in the red, adding more risk is not wise because it can make a bad situation worse. Leverage is an important part of any trading strategy however it must be used during the most optimal trading opportunities to maximize profit.

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