One of the most critical elements of successful online financial market trading is to determine your risk appetite or your tolerance to risk. Simply stated, how much of your investment can you afford to lose while trading on Contracts for Difference (CFDs)?
At the outset of this article, it should be noted that there is no such thing as 100% risk-free investing. The title of this piece is a misnomer and should instead read “5 Guidelines to Reducing your Investment’s Exposure to Risk.“
As Sami Abusaad notes (and Jones Mutual concurs), you have to be “willing to lose money on a trade. If not, then don’t take it. You can only win if you’re not afraid to lose. And you can only do that if you truly accept the risks in front of you.” Therefore, successful financial market trading is not about trading risk-free, it’s about reducing exposure to risk by making wise trading decisions.
Another way to look at risk management is to see it as the foundation of your house. If your foundation is not stable, then there is very little chance that the building will stay standing in adverse conditions. In the same way, if your risk management plan is not reliable, your trading strategies will fail, and you will lose large sums of money.
Guidelines to reduce your exposure to risk
Here are five ways to help you reduce your investment’s exposure to risk:
Determine risk appetite beforehand
Risk appetite is the percentage of your initial investment that you can afford to lose while financial market trading. Risk appetite is generally noted as the following three levels: High-, medium-, and low-risk. Several indicators can be used to determine how high your investment’s exposure to risk is. The biggest of these indicators is age-based. As a rule of thumb, the younger you are, the higher your risk appetite and vice versa.
Plan your trading strategies carefully
Sun Tzu, Chinese General, military strategist, and accepted author of “The Art of War” notes that “strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat.” It is absolutely vital to take the time to study the financial markets and to plan your trading strategy before you enter the market and open trading positions.
Furthermore, it is equally important to stick to your trading strategy once you have planned it correctly. Changing trading strategies in the middle of a trade will more often than not lead to disaster.
Do not trade on emotions
Trading CFDs is inherently volatile. By definition, a Contract for Difference leverages a linked asset’s (like Forex pairs and cryptocurrencies) price volatility to derive a profit. Under normal circumstances, the price of a Forex pair only moves by 100 pips per day.
However, under extreme conditions, the asset’s price can swing radically up and down in a very short space of time. Consequently, it is easy to panic and to change trading tactics midstream without considering the consequences. This is known as emotional trading, and it can lead to substantial losses. Thus, it is vital to stick to your trading strategy no matter what the market does.
Build risk-management into your trading strategy
You should decide how much you are willing to risk on each trade before you place a trade. There are many formulas you can use. Here are two of the more popular equations that most traders use:
- The 5/15 rule: Essentially, you risk a maximum of 15% of your total equity at any given moment. Each trade can be no more than 5% of the overall 15%. Therefore, you can only place three trades at a time. For example: if your total investment is $600, 15% of the $600 is $150. Furthermore, 5% of the 15% is $50. So you can open a maximum of three trades of $50 each.
- The 2% risk rule: The main idea here is you risk 2% of your overall equity on each trade. Although this algorithm is similar to the 5/15 rule, the 2% rule allows you to enter more than three trades at any given moment. For example, if your total equity is $600, then 2% of $600 is $12. $12 is much less than the $50 per trade in the first example; however, there is no restriction on how many trades you should open using the 2% rule.
CFD trading can return substantial profits or cause equally significant losses. It is vital to implement these risk-reducing strategies to ensure that you leverage the maximum amount possible and reduce your losses to the bare minimum.