Constructing Trades with Risk Management Rules
In this section, we will look at ways to structure trades and manage risk when spread betting. To be sure, these aspects of trading might seem less exciting but many experienced traders would argue that these strategies are some of the most critical elements in determining a trader’s true ability to generate profitable returns over the long term. This, after all, is why we start spread betting in the first place so in this section we will look at some of the ways successful traders manage position risks.
Start Your Planning with Risk Assessments
When trading , we will define risk as the maximum amount of capital that is exposed to possible losses at any given time. When looking to manage this risk and structure trades, the first point to consider is the amount of money that might be lost if prices later move in an unfavorable direction. Since there is no trade that has a 100% guarantee for success, this protective approach must be taken before potential profits are considered.
For many new traders, this approach would appear to be counter-intuitive but since there is no trade that can be considered a “sure thing” (no matter how solid your analysis might be), this is the only way to maintain a protective stance. Many advertisements for trading systems claim to have methods that are “flawless and fool-proof,” but the unfortunate reality is that this is simply not possible. It is certainly possible to develop trading systems that consistently beat the markets but since any trade carries with it the possibility of failure, traders must structure that amount of trading capital being risked in the position and then limit that number to a level that is acceptable for your risk tolerance.
Set Rules for Position Sizes
Once you set limits for the amount of money you are willing to risk on each trade, the next element to deal with is the total position size you will use in your regular trading. As a general rule, the number of assets in each position will depend on your total account size. Those with smaller sized trading accounts (in terms of money deposited) should use smaller position sizes. This, of course, will limit the your potential for gain in any given trade but it will also protect you from crippling losses that will irrevocably damage your account (and prevent you from trading again).
When setting rules for each position sizes, most experienced traders recommend that no more than 2-3% of your total account be put at risk at any one time. This essentially means that if you have one open position, and $5,000 in your trading account, your risk parameters should be no larger than $100 to $150. So, for example, if you are trading with the Euro and your position is set to $1 per pip, your trade should be limited with stop losses no more than 150 pips away from your entry price.
Use Leverage in a Conservative Fashion
Now that we understand how position sizes should be measured in relation to total account sizes, the next factor to consider is the use of trading leverage (margin). Leverage allows traders to use broker credit to maximize their trading sizes, and this creates the potential to significantly increase potential gains when the outcome of the trade is positive. When increasing position sizes in this manner, all gains and losses are attributed to the trader, and your broker will receive no extra payment (despite the fact that you were able to make more money in the trade).
It should be remembered, however, that a “free lunch” does not exist in the financial markets and when trades have a negative outcome, the losses are equally magnified. Because of this, traders with a more conservative mindset will typically use leverage in small amounts – or even use none at all. More aggressive traders, however, tend to show a willingness to take on more risk and use leverage to maximize the potential for gains.
Regardless of your approach, however, many traders establish rules that prevent leverage levels from exceeding 10:1. This means that if you invest $1,000 in the S&P 500, you will only need to use $100 to open the position. Your broker will put up the remaining $900 but all of the gains or losses that are attributed later will be credited (or debited) to your account. The use of leverage is an attractive advantage of spread betting trading when compared to more traditional forms of investment. Leverage ratios can be changed to meet your trading style, and, in some cases, can be as large as 500:1. Experienced traders, however, tend to recommend that any leverage above 10:1 will expose a trading account to unnecessary risks.
Risk to Reward Spread Betting Ratios
Our last topic in the trade construction and risk management section will deal with “risk to reward ratios.” This is another critical element that must be understood by traders in active positions, and essentially refers to the amount of money put at risk, compared to the amount of money that might be gained in a trade. For example, if we buy a stock that is trading at $25, and I expect its value to increase to $30, I believe am able to make $5 in the position. To protect myself from excessive losses, I will place a stop loss at $23. Here, my potential losses will be equal to $2. Together, this means I will have a risk to reward ratio of 2.5:1 in this trade ($5 potential in gains, divided by $2 in potential losses). Most traders require risk to reward ratios of at least 2:1 in order to execute a trade. Anything lower than this represents an unfavorable trading parameter and the trader should look for other opportunities.