Online trading is about more than maximizing gains. Traders also aim to minimize their losses by keeping the risk factor as low as possible. What are the most effective ways of identifying and dealing with risks? The good news is that there are several tactics people can employ to achieve the goal of protecting their capital while putting it at risk in a potentially volatile marketplace.
Step one is to create a written trading plan. Other worthwhile tools and techniques include learning to set stops on every order, sizing each position for optimum risk reward ratio, diversifying the trading portfolio, automating routine tasks, establishing limitations on the use of financial leverage, practicing with a demo account to learn core skills, and hedging. Explore the pertinent details of each approach below.
Develop a Trading Plan
Without a trading plan, you’re flying blind. There’s no sense in moving from transaction to transaction, implementing whatever rules come to mind based on current conditions. Develop a detailed plan that includes specific rules of engagement. What do typical plans look like? Most are lists of guidelines about how much capital to spend on each trade, the types of assets to buy and sell, how many trades to make per session, the maximum acceptable loss per transaction and per day, where to set stop loss and stop gain points, how to size each position, and more. Make a plan that meets all your needs and suits the amount of capital you’ll be putting at risk.
Stop Loss & Stop Gain Orders
Stop losses are the heart of account management for CFD enthusiasts who operate via online brokerage platforms. That’s because setting a specific, numerical maximum loss point on each transaction is the most effective way to protect capital. Aspiring traders can minimize account shrinkage by designating a maximum loss when purchasing a CFD.
On trading platforms by AvaTrade, account holders can set specific stop loss amounts based on their own calculations and risk tolerance parameters. The system will automatically take you out of the position once the value of the contract declines to your stop loss point. Likewise, many people set stop gain points, also known as take profit orders. They do the same thing as a stop loss, except on the positive side by locking in gains and getting you out of the position with a profit.
Position Sizing
It’s imperative to set the correct position size on each transaction. If you wish to buy a share of stock that lists for $100 and set an appropriate stop loss, then calculating the position size would require knowing the risk tolerance or maximum acceptable loss. Using a 2% maximum budget per transaction based on available capital, with an account balance of $10,000, you could risk $200 on the trade.
Note that risking $200 means setting the stop loss so that the system takes you out of the position once the price declines to the point where you’d lose that much money. In this case, you could purchase 100 shares @ $100 each ($10,000 total) and set the stop-loss at 2%. If the price moves to $98, the platform’s system will close your position because the loss amount would be $200.
Diversification
Diversifying a portfolio is one of the easiest ways to protect capital. The most common way to achieve diversification is to include different asset classes in your holdings, like stocks, ETFs (exchange traded funds), options, and more. However, there’s another way to diversify without moving outside of one asset class. A stock enthusiast might acquire blue chips, low-cap, tech shares, and other kinds of stocks within a given portfolio.
Practice with a Demo Account
Knowledge is power. Honing your skills with a demo account is one of the simplest tactics for learning how to place orders quickly and execute trades in real time. The beauty of using a simulated account is that no real money is at risk. Practice for a few days to get the hang of a new platform and acquire the confidence needed to use your own funds in real markets.
Set Leverage Limitations
It’s smart to keep track of leverage. That’s the amount that the broker allows you to borrow on a particular trade. A leverage of 10:1 will give traders the ability to make a purchase ten times the amount of the funds they spend. While leverage can work for you in terms of magnified profits, it has another side. Losses can outstrip your capital resources. However, on smaller transactions, most account holders are careful to limit leverage so there’s no chance of a blowout.