Trading is easy; properly managing the risk in those positions when they go sour is hard. That’s why many traders believe that proper risk management is the key to trading success.
Winners can easily turn into losing trades if you don’t implement proper risk-management techniques. That said, here are some tips to managing risk correctly.
Proper position sizing is one key to success, and a spot where many beginning traders mess up.
A good rule of thumb is to never risk more than 1 percent of your capital in any one trade. For example, if you have an account with $10,000, you wouldn’t want to risk more than $100 per trade. Using this rule would allow you to get in more trades when you’re first starting out, and not get blown out by any one position.
Risk-reward and setting stop losses
Only trading situations with a high risk-reward ratio also helps determine trading success. Generally, you want to get into trades in which the risk-reward ratio is greater than 1 to 2. In other words, for every $1 you risk, you could potentially make $2 or more.
Here’s an example of proper risk management, illustrated by this chart on Target Corp. (TGT)Source: TradingView
Let’s assume you got long the stock, after the 3-day exponential moving average crossed above the 8-day exponential moving average. Your target exit price would be around $58, slightly below where the stock previously gapped down. Additionally, you would stop out of the position, if the stock price closes below the 8-period exponential moving average. Now, your risk-reward would be greater than 1-to-2 here.
Take a look at how the price action played out:Source: TradingView
Once you create a rule, make sure you follow it. Here, we noted that you would get out if the stock price closed below the 8-day exponential moving average, and you would have gotten out of the position, still for a profit.
The bottom line
Understanding risk management is every bit as important as being able to identify good chart patterns or read an income statement when it comes to successful trading. Proper position sizing, only getting into trades with attractive risk-reward ratios and setting stop losses should give you a jumpstart, and could potentially help you develop a rules-based trading system.
Petra Hess runs PetraPicks.com. She is a technical swing trader and long-term investor in domestic and Canadian stocks and ETFs.