|Risk:||The inability to gauge future performance due to high levels of fluctuation between returns and losses. Usually, risk increases alongside potential profit and/or loss.|
Risk & Reward
Risk & Reward - text
Risk and reward is a very important concept in the context of trading. It defines the balance that a trader should have between how much monetarily, they are willing to risk in relation to the amount of reward, or profit that they seek.
When implementing risk and reward, you can essentially curb the likelihood of wiping out your entire trading capital by ensuring that you only risk sensible amounts of your money, and ensuring that you can justify the amount of capital you are prepared to risk in relation to the amount of profit you aim to acquire on each trade.
Accordingly you may risk more if you expect to take more profit and risk less when you have lower conviction or less expectation or making profit.
There are different ways of implementing risk and reward measures into your risk management strategy to ensure that you enjoy more profitable trades and a well-preserved trading account.
First and foremost, you can implement what are known as risk-reward ratios. In essence, you will stake a certain amount on a trade, with a view to securing a certain level of profit. It would be hard for you to implement a risk-reward ratio without quantifying it.
Let’s look at an example; the minimum risk-reward ratio which you should implement is a 1:2 ratio.
If you had a profit target of £50, according to the 1:2 ratio, the most you should be prepared to lose should be £25. Be aware that this 1:2 ratio is the riskiest ratio you should ever look to implement.
There will be market situations and factors which may cause you to implement ratios which are even more cautious in nature, such market volatility and volume. As such it might be more advisable for you to use risk-reward ratios such as 1:3, 1:4 or higher.
The maximum proportion or percentage of your trading account which you should be willing to risk on any one trade is 5%. In essence, if you have £2,000 of trading capital in your account, the most that you should be willing to risk is 5% of this, i.e. £100. Keep in mind that you should also be looking to take a £200 profit on this trade as well.
If you were to lose £100 in the trade, you would still have £1,900 in your trading account. With the smaller amount of £1,900, you would only risk £95 (5%). By the same token, you would be able to risk more capital per trade as your trading account was to grow. The risk you face if you don’t implement a rule like this is that you risk losing everything in your trading account, all in a matter of a small number of trades.
Of course the nature of trading is that you may see value in a number of different markets, not just one. You may see opportunities in a few different markets at the same time. In such a circumstance, you should still look to adopt a maximum to the amount of trading capital you are prepared to risk.