Risk is the amount of money you can lose when you trade securities. Risk is not the actual loss but the theoretical loss. When you trade you want to make sure that your risk is in line with your financial goals. If you are not willing to lose more than a specific dollar amount, then you need to come up with a strategy that will limit your risk. There are several tools that you can use to help you create a risk management plan. This includes technical analysis tools, diversification, and strategy overview.
Developing a Risk Management Plan
The first step to developing a risk management plan is to determine how much capital you plan to risk. Any asset that you plan to eventually sell excluding a primary home, should incorporate a risk management plan. You need to start with the amount you are willing to lose to back into the amount that you can realistically gain. The capital that you allocate should be discretionary capital and not money that you need to live on. The capital that you plan to risk then needs to be allocated to the strategies that you plan to employ. Once you have allocated capital to a strategy, you can then decide on a risk versus reward ratio.
The amount that you plan to gain should be a multiple of the amount you plan to risk. Ratios of 2x, 3x, 4x, or 5x are realistic goals. This means that if you plan to risk $1,000 then earning $3,000 from your trading venture throughout 12-months is a particularly good plan.
To make 2X your capital, you need trades that will equal those gains, while only risking the capital you initially deployed to a strategy. While each trade does not have to win 2, while only losing 1, the sum of these trades should focus on winning $2, while only risking $2.
Using Technical Analysis
After you have determined the overall risk management plan for each trading strategy, you need to employ this risk management at the trade level. You can use many techniques to apply your risk management strategy, including the use of technical analysis. Recall, technical analysis is the study of past price movements that allow you to find support and resistance levels that you can develop a risk management strategy. Here is an example of how to use moving averages and trend lines to risk $1 to make $2.
In this example, you can consider short-selling the EUR/USD at 1.0850, risking 1-big figure, and placing a stop loss at 1.095 above the 40-day moving average. Your take profit could be the lows made in March at 1.064, allowing you to make 2X the amount you plan to risk.
An alternative is to just look to make a specific percentage on each trade. For example, you are willing to risk 1% to make 2% or 3%. You can use several different moving averages or downward or upward sloping trend lines to find the support and resistance levels that will help you develop a risk management plan.
The Bottom Line
The upshot is that when you trade you want to make sure that your risk is in line with your financial goals. If you are not willing to lose more than a specific dollar amount, then you need to come up with a strategy that will limit your risk. The best way to do this is by creating a risk management plan. There are several tools that you can use to help you create a risk management plan. This includes allocating assets to different strategies as well as technical analysis tools, that help you manage each trade.
