The Bulls & Bears through our affiliates provides a full range of educational tools and customer support services for our valued clients. The world of trading can be complex and daunting without appropriate support, which is why we place so much importance on support across markets and trading conditions. Whether you want to trade forex, cryptocurrencies, shares, or derivatives, there's a number of underlying factors that influence the trading experience.
Risk management is integral to every successful trading strategy. It's not enough to maximise profits, you also need a way to minimise risks and avoid unwanted levels of market exposure. In fact, some people focus almost entirely on minimising their losses, especially during the early stages of trading. Even a successful trader can lose all of their profits in just one or two bad trades if a sound risk management strategy hasn't been employed.
Risk management requires a multi-pronged approach, with typical points of focus including risk/reward ratios, stop-loss orders, and market exposure analysis. It's not enough to have consistent winning trades, you also need the value of your good trades to outweigh the value of your bad trades. While everyone trades in their own unique way, stop-loss orders, disciplined profit taking, and low levels of capital exposure are generally advised to help reduce risk and enhance profitability.
The risk/reward ratio is a measurement of your potential risk related to your potential profit. For example, a risk/reward ratio of 1:2 means you're risking $1 in order to potentially make $2. A risk/reward of 1:5, while unrealistic in most market conditions, means you're risking just $1 to make a possible $5.
While a lot of trading guides recommend a risk/reward ratio of at least 1:2, the accuracy of this statement also depends on your trading strategy and winning percentage among other variables. For example, if you have a winning percentage of 90%, which is unrealistic, you may still be profitable with a negative risk/reward ratio. Even a ratio of 3:1, which means you lose $3 for every $1 that you make, will have a positive outcome at the end of the day ($3 x 10 < $1 x 90).
Such a high winning percentage is unrealistic, however, which is why so many people advocate for a positive risk/reward ratio. While it's important to keep this advice in mind and look for trades with the potential to make big profits, it's also important to stay flexible and adapt your ratio depending on liquidity and other market conditions.
STOP-LOSS AND TAKE-PROFIT ORDERS
A stop-loss order is the mechanism that most people use to define their risk for each trade. A stop-loss point is a defined price where a trader decides to take a loss on the trade. While this point doesn't need to be entered into an actual order, stop-loss orders are recommended in the vast majority of systems in order to prevent huge losses. Without an actual stop-loss order, traders may fall into a "it will come back" mentality, which can be incredibly dangerous and lead to entire accounts being wiped out.
On the other side of the coin, a take-profit point is the price where a trader decides to take a profit on the trade. While this can also be set in a market order, many people leave their take-profit points open and adapt them as price changes over time. The stop-loss point, take-profit point, and risk/reward ratio are intimately connected, with the later defined as the ratio between the stop-loss point and the take-profit point. While a positive risk/reward ratio is not required in every successful system, a negative ratio can only be sustained when there is a very high winning rate.
Along with your risk/reward ratio and how it's defined by market orders, it's also important to think about capital exposure in relation to your wider trading strategy. For example, while some traders will be happy to risk 5 per cent of their capital on a single trade, others will want to limit their risk to 0.5%. Most trading systems recommend a hard limit of 2 per cent risk per trade in order to avoid huge losses, with lots of traders more comfortable with 1 per cent or even lower depending on their starting capital and overall strategy.
In order to understand exposure, it's also important to understand leverage and margin levels. Leverage involves borrowing a certain amount of money in order to make an investment or trade. In forex and other markets, traders typically borrow from their broker every time they want to make a trade. While high leverage can be powerful because it allows traders to work with more money than they physically have, it can also be incredibly risky. When using leverage, it's important to define your market exposure in real money and percentage terms for every single trade.
How to Set Orders
It's impossible to give accurate advice on how to set stop-loss and take-profit orders, with each individual trading strategy defined by its own specific constraints. Generally speaking, however, you should place your stop-loss at a point where market evidence deems your decision to be wrong. This can be much harder than it sounds, with a strong sense of discipline and mental focus needed to avoid making emotional and irrational decisions.
The same can be said for take-profit orders, which should be carried out when market evidence points towards the conditions of your correct decision being over. While technical systems often place stop-loss orders below or above support and resistance lines, traders using fundamental analysis may have entirely different reasons for placing market orders at specific points.
Regardless of your trading system or method of market analysis, it's always important to choose stop-loss and take-profit levels based on specific time frames of analysis. For example, if you've spent days analysing the markets on the hour chart, it makes little sense to choose a loose stop-loss point based on the day chart. Always remember to zoom in and out of the charts based on your intended risk and exposure.
Along with a detailed understanding of technical analysis, fundamental analysis, and specific market orders, it's also important to look into trading psychology and how it can impact your decision making. While everyone has heard about the psychological effects of trading, it's almost impossible to understand how powerful they can be when you have no direct experience in the markets. While you'll always require some kind of technical edge, in many ways, mastering your psychology is the key to trading success.
Above all else, successful traders have found a way to analyse the markets and carry out disciplined processes while managing their emotions in a range of market conditions. A number of factors can upset a trading system, with the principal offenders being fear, greed, expectation, and regret. Are you too scared to enter the market even when your system points towards success? Are you being too greedy and leaving yourself open to loss? Are you willing to adjust your expectations when market evidence changes? Does regret or fear of missing out (FOMO) influence your decision making?
While it's impossible to totally rid yourself of emotions, you can do a lot to manage them. A rational mindset and the ability to follow clear and consistent trading rules are integral to every successful trader. Whether you're using multiple indicators, trading on naked charts, or involved in detailed fundamental analysis based on international trade reports, every single trader needs to be in control of their emotions if they want to avoid making bad decisions. While meditation and mindfulness can be useful, like most things in life, developing trading discipline is mostly the result of hard work, practice, and patience.