Before you place your first trade, you should consider creating a risk management plan that will help you navigate your trading strategy. Risk management is a framework that helps protect you against losses and allow you to reach your financial goals. You can generate a risk management strategy for individual trades which will help you with short term trading as well as allocating assets to a specific endeavor to help you with long term investing.
What is Risk?
Risk is the amount of capital that you can potentially lose on a trade. Its not the actual loss you experience but the potential loss you could experience. Risk management is a framework that you create to mitigate your risk.
Using a Stop Loss for Risk Management
One of the best ways to mitigate your losses, is to develop a risk management strategy that deals with each trade. Before you place a trade, you should determine the amount you are willing to risk, to achieve the gains you require. Your stop loss can be a percent, a dollar (or other currency) figure, or even a level on a chart.
One popular way to determine your risk is to look for levels of support and resistance. For example, if you were short the EUR/USD you might consider placing a stop loss above the 100-day moving average. You might even use a trend line, which is depicted in the chart above. Once you determine your stop loss level, you can then attempt to determine how much you believe you can make given the risk you are willing to accept.
In this theoretical example you might consider shorting the EUR/USD at 1.1160 and stopping out at 1.13 which is a downward sloping trend line. You might consider taking profits at the 10-day moving average at 1.1015. In this instance you would be attempting to make 0.0145 and risking 0.0140. This is a risk to reward ratio that is slightly above 1. Generally, you should be looking for a risk to reward ratio above one.
Long Term Investing
One of the best ways to manage your long-term risk is to allocate funds to several different investing strategies. You might consider using a buy and hold strategy in conjunction with a short-term trading strategy. You also might diversify they assets that you invest in. You might have some in stock, and bonds as well as commodities or even real estate.
By using a combination of short term stop losses and take profit levels, as well as asset allocation, you can generate a risk management framework. Your short-term risk management should focus on stop loss levels that help you create a risk to reward profile. Asset allocation is geared toward a long-term risk management strategy, which can help you diversify your portfolio and generate long stable returns which will help you expand your wealth.