TRADING PSYCHOLOGY RISK MANAGEMENT
HOW CAN I CONTROL MY EMOTIONS AND BE MORE DISCIPLINED IN TRADING?
In our first Trading Psychology blog we wrote about the importance of money management in mitigating the risk inherent in all leveraged trading. It doesn’t matter whether you’re spread betting or trading CFDs; whether you concentrate on FX, individual equities, commodities, stock indices or trade a bit of everything. When you trade on margin and employ leverage then it’s vitally important to spend time and effort incorporating money and risk management into your trading plan.
In trading psychology everyone will have their own attitude and tolerance towards risk. But the bottom line is that leveraged trading exposes you to the possibility of losing more than your original deposit. This can be offset to a great extent by careful money and risk management, particularly if utilising guaranteed stops which protect you against even the most violent and unexpected market movements. But in this blog I want to look at some aspects of stop selection and how it relates to money management in trading psychology.
Let’s assume that you are fortunate enough to have £5,000-worth of risk capital - that is, £5,000 that you could afford to lose should the worst happen and none of your trades prove profitable. Now based on trading psychology, the rules on money management tell you that you should divide this up into a number of tranches so that you’re not risking too much on each individual trade. In this instance “risk” is defined as the difference between the opening level and stop level of the trade, multiplied by the bet/trade size. Some traders say you should risk no more than 1 or 2% of your risk capital on each trade. With £5,000 this would suggest 100 trades risking £50 each time, or 50 trades risking £100. Of course, a less risk-averse trader could decide to divide up his or her capital into 20 tranches of £250. So what we’re saying in this example is that the difference between your opening level and stop level, multiplied by your bet/trade size should mean risking no more than £50, £100 or £250.
Now for any given amount of risk capital, the more you risk per trade means fewer overall trades. However, risking a larger amount per trade has the advantage of providing a greater number of potential trading opportunities. Risking a maximum of £250 on each trade means you would be able to take positions in markets which are typically volatile. Obviously, each trade will carry more risk than a position with a £100 or £50 limit on it, but it also means that you can place your stop further away (all trade/bet sizes being equal) which will give your trade more time to breathe and come to fruition.
TRADING PSYCHOLOGY RISK MANAGEMENT: EUR/USD SPREAD BETTING EXAMPLE
In the chart below we can see a low-high move in the EURUSD with a Fibonacci Retracement on it. A trading opportunity presents itself after the pair retraces 76% of its initial move and you decide to buy. Your buying level is going to be somewhere above 1.0520 or so, and for the purposes of this example we’ll say it’s 1.0535. Now, you decide to place your stop a touch underneath the old low of 1.0495 - let’s say 1.0480. Consequently, and assuming the pair doesn’t gap below your stop, your potential loss is 55 points. If you were to do a minimum spread bet of £1 per point then your potential risk is £55. Consequently, if your money management rules say that your maximum risk per trade is £50 then you mustn’t place the bet. Obviously, you could if you’re prepared to risk either £100 or £250. In fact, you could buy up to £4 per point with the latter.
it is important not to confuse your “risk per trade” and Spread Co’s margin requirement per trade. You must always hold sufficient funds in your account to cover the margin requirement on your open positions, together with any variation margin required. So, if the market has moved against you, but not far enough to trigger your stop, you may find that the combination of the initial margin requirement together with the variation margin requirement means you would need to hold funds in your account over and above the £50, £100 or £250 earmarked for a specific trade. Of course, this isn’t a situation which would arise if you were employing guaranteed stops.
Money and risk management are vitally important factors in the trading process. Getting this right will help you feel comfortable with your financial exposure to the markets. This in turn will go a long way to take emotion out of your trading so you can concentrate on the markets themselves.