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  • Risk Management Guide

    Risk Management Guide

    Risk control is an essential part of successful trading. Effective risk management requires not only careful monitoring of the amount of risk, but also a strategy to minimize losses. Understanding how to control the amount of risk allows the trader, novice or experienced, to continue trading even when unexpected losses occur. One of the contributors to Stocks & Commodities offers a guide to risk management.

    Since each trade is subject to a certain degree of risk, applying some general principles of risk management will reduce the potential loss. Some generally accepted axioms of risk control are listed below and can be applied by anyone who has ever traded or thought about it.

  • #2
    Rule 1: Do some preliminary homework.

    Doing your homework before a deal is a commitment that cannot be replaced. For every buyer there is a well-informed seller and for every seller there is a well-informed buyer. Everyone is trying to maximize their profits. Before putting your money at risk, you must have a solid, well thought out reason why you want to buy what someone else wants to sell. Above all, trading is a capital-building game. Ask yourself, what do I know that the seller (or buyer) does not know? Be careful and show some degree of respect for the person on the other side of the counter.
    You must be clear about the kind of financial risk you may face at any time. Part of the homework involves assessing the potential loss if the market moves against you by 5%, 10%, or 20%. Doing some preliminary homework on trading will help you figure out the worst possible outcome, potential exposure to risk as well.

    You can mitigate your risk by limiting yourself to deals that you can foresee (that is, doing your preliminary homework). We know of one trader who rushed to buy orange juice futures after a sudden cold snap in Florida. It was only later that he realized that frost-damaged oranges could be sold to make orange juice. In reality, the sudden cold snap increased, rather than diminished, the supply of orange juice, and the oversupply drove orange juice futures prices down. If the trader did the preliminary homework, he would know what to expect.

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    • #3
      Rule 2: Create a trading plan and stick to it.

      Each trader must create his own trading methodology. A trading methodology or model can be based on fundamental factors, technical indicators, or a combination of both. The methodology should be extensively tested and reworked until it demonstrates the desired and lasting positive result. Before investing money, make sure your trading methodology is reasonable and profitable.
      An important part of your trading plan is to set a limit on the amount you can lose. If you reach this limit, exit the game. Stick to your trading plan and avoid impulsive trades. If you don't follow your plan, then you don't have one.

      A trading plan helps you identify and evaluate the key factors that influence your trades and can be an important teaching tool for follow-up trades. A sensible trading plan will give you the confidence you need as well. It is also unlikely that with a specific plan in place, you will trade impulsively.
      However, do not blindly follow the trading plan. If you do not understand what the market is doing, or your emotional balance is somewhat disturbed, close all positions.
      When creating your trading strategy, do not listen to a broker and do not invest based on market advice or rumors. Your money will be at risk. Before trading, do your homework and think about your own rationale for the trades.

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      • #4
        Rule 3: Diversify.

        Portfolio risk is reduced through diversification. Don't bet all the money in one trade. Diversify your risk exposure by trading no more than 1% - 5% of your capital per position. (Contracts with different expiration dates for the same contract count as one position.) Consider diversification in different markets and with different trading systems.
        To be effective, diversification must include securities that are not highly correlated with each other (that is, they do not move in the same direction at the same time). A high positive correlation reduces the benefits of diversification. Closely monitor the connections between all your positions, unbalance and adjust your portfolio.

        Predefined stop orders limit your risk exposure and reduce your losses in fast moving markets. Adopt a strict stop loss rule, for example, quickly exit the game if you lose 5% -7% - and follow it.

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        • #5
          Rule 4: Don't invest all your money.

          Before entering into a trade, make sure you have sufficient capital to compensate for the unexpected loss. If the opportunity looks unexpectedly profitable, then you may be overly optimistic. Markets are usually rarely as good as they might seem at first glance. If the market turns down unexpectedly, it is wise to have some capital available to offset small losses or additional margin calls. Some capital set aside for additional purchases reduces stress, reduces the need to take unnecessary risks and usually helps to sleep better at night .

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          • #6
            Rule 5: Apply Stop Orders.

            Predefined stop orders limit your risk exposure and reduce your losses in rapidly changing markets. Adopt a strict stop loss rule, for example, quickly exit the game if you lose 5% -7%. Even the most experienced traders, let alone the lucky ones, use stop orders to limit their exposure. Make a commitment to quit the game if your plan doesn't work. Stop lights are there to protect you. Use them when you start the game.

            Some traders use timed stop signals. If the market does not behave as you expected, exit the market even if you have not lost money. Timed stop signals remind you to exit the market if you are unsure of what is really going on.

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            • #7
              Rule 6: Trade with the trend.

              It is unlikely that you will suffer a loss if you follow the market trend. The direction of the market does not matter as long as you have a position on the emerging trend. If you have an unsuccessful position, then systematically reduce the amount of risk.

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              • #8
                Rule 7: Make mistakes and suffer losses.

                An important aspect of risk control is the ability to admit that you are wrong and quickly exit the game, even if it means losing money. Even the best traders suffer losses from time to time. But we all hate to admit our mistakes, so this rule is difficult to follow. The axiom is simple: let profits accumulate and reduce losses. Reduce your risk if the market moves against you. Do not add to a losing position in the hope of making up for the loss. If you do not understand what the market is doing, exit the game. Also, do not immediately after a losing trade make the next trade in the hope of recouping - you must first cool down your emotions.

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                • #9
                  Rule 8: Trade with Protective Measures.

                  Paul Tudor Jones put the great idea of ​​trading in football terms: "The most important rule of trading is to play great defensively, not great offensively." Think first about what you can lose and compare it to the possible gain. It is better to take into account the possibility of a negative development of events in advance and draw up a plan than to change everything later after a fait accompli.
                  Constantly assume that the market may start moving against you - and prepare for this in advance. Calculate the maximum possible use of the credit. If necessary, adjust the stop signal levels where appropriate. Create a market exit plan. Therefore, when the market starts moving against you, you will be ready for this. Protect what you have.

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                  • #10
                    Rule 9: Don't overtrade.

                    Reduce your risk by cutting back on trades and keeping rates low. Be selective about the risks you are exposed to. Limit deals to the one that is most attractive. This will force you to do preliminary homework and reduce impulsive and emotional transactions. Since there will be fewer deals, you will be more patient. Fortunately, fewer trades also reduce the amount of commission you pay.

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                    • #11
                      Rule 10: Control your emotions.

                      All traders experience severe stress and losses from time to time. Anxiety, frustration, depression, sometimes despair, are all part of the game in the marketplace. Part of managing risk is the ability to control these emotions. Don't let your emotions drive your trading. Focus on what you are doing. Trade based on informed, rational decisions, not emotions and fantasies.
                      Chatting with other traders is one way to maintain control over your emotions. Other traders understand the challenges you face and can provide important emotional support when your courage runs out. It helps you understand that you are not alone and that others have faced and experienced similar problems.

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                      • #12
                        Rule 11: When in doubt, quit the game.

                        Personal doubts indicate that something is wrong with your trading plan. Exit the market quickly if:
                        • The market is behaving irrationally;
                        • You are not sure about the position;
                        • You don't know what to do;
                        • You cannot sleep at night.
                        Before you put your money at risk, you need to be sure exactly what you are doing and that you will be lucky.

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                        • #13
                          Conclusion

                          There are four main stages of risk management:
                          • - Full understanding of what risks the transaction is exposed to.
                          • - Eliminate, if possible, risks that are not necessary.
                          • - Be choosy about what risks you can expose to a trade.
                          • - Act quickly to reduce your risk if the market moves against you.

                          For many traders, the key to managing risk is the ability to cut losses before they lead to ruin.

                          Edwin LeFevre, author of "Reminiscences of a Stock Operator" wrote: "The enemies of the trader that lead him to death: ignorance, greed, fear and hope." While these internal enemies will never be defeated, effective risk control techniques can minimize their negative impact. A rational risk control strategy, on the other hand, should lead to smaller and less expensive unprofitable trades.

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