How to manage your trading risk
A disciplined risk and money management strategy is very important to every trader. Below are some helpful pointers on how to effectively manage your trading risk when trading a leveraged product like CFDs. There are a few golden rules that should always apply. Fortunately, at Capital Index you can use stop orders to help control your risk.
Only invest money you can afford to lose
This may sound obvious, but many traders do not take this basic concept into account. You should never fund your trading account with capital you cannot afford to lose. The capital you choose to trade with, should not be money needed for day-to-day living, and your individual financial status should be taken into account - personal income, expenditure, emergency funding, etc.
Experience is gained over time, but sound money management practices from the start will ensure you are not left in a compromising and potentially devastating financial position, should a trade not go your way or losses accumulate. This leads us to the next point, regarding the risk percentage per trade.
The 2% capital risk rule
Many traders believe you should only risk a maximum of 2% of your total trading capital on each trade. This concept is particularly popular amongst new traders, who may choose to risk a maximum of only 1% per trade at the beginning. Let’s take a quick look at two simple examples one using the 2% rule and the other using the 1% rule.
Trader ‘A’ has $10,000 in a trading account. Following a risk rule of 2%, this would ensure trader ‘A’ should not lose more than $200 on any single trade if the trade is not affected by slippage or gaps in the market.
Trader ‘B’ also has $10,000 in a trading account. However, trader ‘B’ follows a risk rule of only 1%. This would ensure trader ‘B’ should not lose more than $100 on any single trade if the trade is not affected by slippage or gaps in the market.
If you set a trading strategy that risks only a small percentage of your capital per trade, without being greedy, it will ensure you avoid any major losses from a single trade. This means no single large trade that has the potential to cripple your account balance if the trade goes against you.
Use Stop Loss and Take Profit orders
It is important and good practice to use a ‘Stop Loss’ order and set a ‘Take Profit’ order. These can both be set when you are first placing your trade, or modified at a later date. However, it is advisable to set them both as soon as possible.
Stop loss and take profit orders are both orders placed in the market to close an open position at a predefined level, although they serve very different purposes. A Stop Loss order aims to mitigate larger trading losses if a trade is going against you. A Take Profit order on the other hand locks in a potential profit before the market may change in the opposite direction to your trade. It protects your profits from being lost in an unexpected reversal of price direction. You can use stop orders to open long or short positions.
Stop loss → an order to automatically close a position once it reaches your specific pre-set price of how far you will let the market move against you before closing out your losing trade. However, be aware of slippage and gaps in the market.
Take profit → an order to automatically close a position once it reaches your specific pre-set profit goal.
Why is it important to incorporate Stop Loss and Take Profit orders into your trading strategy?
Besides the obvious answer of guarding you against larger unwanted losses and locking in profits, they can also help take the unwanted emotion out of trading, for example greed or fear by setting targets when entering the trade.
Stop Loss: You open a buy position on the UK100 at an entry price of 7300. However, you don’t want to risk anything more than a 10 point loss. This means you would create a stop loss order 10 points lower than your entry price at 7290.
Take profit: Again, you open a buy position on the UK100 at an entry price of 7300. This time you would like to set in order to close your trade automatically when the market price hits a certain profit level. In this instance, you may set a take profit price of 7320.
Remember, placing a normal stop loss does not 100% guarantee you will be filled at that particular market price. This could be due to what is known as ‘slippage’. Slippage is the difference between the requested market price and the actual price that the trade was filled at. Slippage is based on two factors, liquidity and volatility. It can occur in fast-changing market conditions or in markets where there is a lack of liquidity
How can you avoid slippage?
You can never fully avoid slippage but trading during normal market hours and outside of major news events can potentially reduce the risk of being slipped.