Risk managament is one of the most, if not the most, important aspects of trading. Traders who are unable to manage their risks properly may end up losing everything by not being able to cut their losses on time, placing trades which are too big and too risky or not spotting an unfavorable price change on time. Although it is nearly impossible to cover all of the aspects of risk management one needs to consider in trading in one article, the guide below should still give you a pretty good idea of several key things to consider.
(NOTE: Before we continue, we have to give a disclaimer that the trading products offered by the companies listed on this website carry a high level of risk and can result in the loss of all your funds. CFDs are complicated instruments that are never guaranteed to provide you supplemental earnings. In fact, Around 68% of all retail investors experienced a loss while trading CFDs. Make sure to keep this in mind before attempting to use the eToro platform yourself. All the information found on this website is not official trading advice and all practices shown are referenced for the use of the Demo account only.)
What is Risk Management?
Before diving into tools of risk management, let’s find out what it actually is. In simple terms, risk management can refer to any techniques involved in assessing, managing and reducing risks and uncertanties involved in financial transactions, such as investing and trading. Considering the entire financial sector, this is a very broad term, really, but this article will focus on short and longer term trading. There are many sources of risks to your trading process and capital, including asset-specific price and volatility changes, sector-specific events and major economic shifts. Constantly considering all of them may be quite overwhelming and eToro offers several tools to help you do so more effectively.
Trading Tools in Short-term trading
Short-term trading is a risky process by definition and relies on making profits on short-term price volatilities, every day-trader at some points runs into losses. However, one needs to ensure these losses do not wipe out their entire account and they are minimized in one way or another. eToro offers plenty of trading tools that should help you manage your short-term trading risks.
Leverage provided by the platform allows you to invest with a greater amount than you actually have on your account. Leverage is a very tricky tool in trading: it can help boosting your returns if used well but it can also wipe out your entire account if markets turn against you. That is also one of the most important things in risk management: a trader needs to ensure that possible losses that could be amplified with leverage do not outweigh gains they can make using it. On the other hand smaller investments which do not employ leverage may decrease the potential profit you are making in successful positions. At the end the size of leverage will depend on the degree of your risk tolerance and ability to control losses it could bring along. Maximum leverage on eToro depends on the type of asset you are trading and are regulated by the respective authorities:
- x30 for the most common currencies and x20 for others
- x10 commodities (excluding gold)
- x5 CFDs on stocks and ETFs
- x2 for the available cryptocurrencies
Stop-loss (S/L) and Take profit (T/P)
Stop-loss is the minimum price an asset can reach before that position will be closed and the loss realized. These two tools are a direct outcome of your ability to plan trades: a trader should know when to exit a trade and how much loss they can take on. Traders that ignore the stop-loss option place themselves in danger of holding onto a losing trade for too long out of a hope that markets will turn and letting their emotions override any reason. A trailing stop-loss is an innovative feature on the eToro platform which allows your stop-loss to follow along upward price movements so you can benefit from positive market trends but still prevent losses beyond a certain level.
Take profit can be used to set the price at which the trader will close down the position and take the resulting profit from it; it basically limits profit’s upside potential. It is mostly used by short-term traders as it allows them to exit a trade as soon as their price and therefore profit target is achieved before a possible price turn in the future. Investors who expect large price rises over a long time period don’t usually use this tool as it reduces their profit potential. Levels of T/P are usually defined through technical analysis, with the use of the trend pattern and support/resistance levels that help to anticipate future price rises and optimal points to enter or exit trades.
There are some things to consider when you choose your levels of stop-loss and take-profit:
- Volatile stocks tend to unnecessarily trigger stop-losses over temporary meaningless price moves, so using longer-term moving averages may be a way to account for that.
- You may also consider adjusting your averages to correspond to price ranges you are targeting.
- Overall, consider adjusting your stop-loss levels to the volatility of the assets you are trading. For instance you may consider tightening your stop-loss in case the asset doesn’t move so much in price.
- Consider fundamental analysis in setting your stop-loss too, accounting for major factors like company earnings reports or management changes that may cause additional price volatility beyond the usual levels.
There is a great variety of trading indicators for eToro users to employ in their trading process. The choice really depends on your outlook, skills and goals for trading. There are 4 general categories of indicators used in risk management which are trend indicators, momentum, volume and volatility indicators. Support and resistance levels, for example, are very popular indicators on a price trend used in risk management which ‘limit’ the range of price movement. Decreasing prices tend to bounce back from their support levels and resistance level indicates points where prices stop rising; they are a good indication of trade strength and helps traders identify entry and exit points to avoid unnecessary losses.
Moving averages that are taken as average prices over a time period smoothes out short-term volatilities and gives traders an overall idea on the direction of price movement and are most basic examples of trend indicators.
Exponential moving averages are very similar to simple averages except that they assign a greater weight to most recent price movements. Likewise, moving average convergence divergence is used to identify strength of a trend and its duration, which assists in minimizing risks by determing best entry and exit points.
Volatility indicators like Bollinger Bands have become increasingly popular in detecting extreme price shifts of a security over short-term periods. Such indicators are bounded by upper and lower bands and the distance between them is determined by an asset’s volatility (measured by its standard deviation). Because they allow traders to spot oversold and overbought periods (where prices are too high or too low based on their standard deviation and a moving average in between, they can identify points of likely sharp price movements and plan their trades accordingly. The position of Bollinger Bands, for example, provides you with the information on the strength of a trend and possible price increases and decreases that can be expected soon, as well as assist in identifying the best entry and exit points for a position.
Stochaistic indicators are a different class of momentum indicators which compare asset’s closing price to past prices over a time period to indicate trend direction, its strength and momentum, as well as overbought and oversold periods. The usual time period for a stochaistic oscillator is 14 days, but eToro allows you to adjust that period depending on your analytical goals. Another indicator is the Fibonacci retracement that indicates the likelihood the price will move against its current trend i.e. pull back. This indicators helps to detect levels of support and resistance and consequently determine points to open and close down trades. Relative strength index (RSI) measures the strength and speed of price changes that happened in the nearest past to determine overbought and oversold conditions of an asset’s price.
It is probably a good idea to use several different indicators at the same time which complement each other (it’s not very useful to use many indicators that basically generate the exact same signals). It is also a good idea to confirm your choice of the strategy for trading a certain asset with an additional indicator that agrees with the trend suggested by another one. Finally, focusing on a few but not too many indicators at the same time will help in making the process of trend identification clearer and less confusing.
Trade planning and strategy
As simple as it may sound, planning out your trades is one of the key factors of success: a trader needs to know which asset positions they will open at what prices using which indicators, how they will manage these trades and when they will exit. A solid yet flexible plan reduces the risks to your capital and limits losses through discipline, avoidance of irrational moves caused by panic and emotions. And of course not to forget the actual process of researching your trades before placing them, conducting a technical or fundamental analysis where most appropriate to determine the best entry and exit points. This also applies to the choice of assets; some instruments are more volatile, such as cryptocurrencies and volatile stocks and you need to have sufficient skills and knowledge to make a profit on them. Although trading plans are certainly personal and depend on your goals and trading style, but these are still some simple questions every trader should be able to answer. One should also consider sizes of their positions. Taking positions that are too large subject traders to large risks in case the price moves against their prediction; sizing your positions well to manage the desired risk levels is very important. There are quite a few techniques out there which traders use to determine trade sizes, such as the Kelly Criterion, which ensures that the size of a position is in relative proportion to the anticipated gain. Traders with relatively small accounts tend to invest somewhere between 1% to 3% into each position to mitigate possible losses from each small trade. For stock trading you may consider scaling your total account to trade risks when choosing trade size. Some traders prefer the equal dollar amount strategy, keeping their investments at equal proportions if they want to avoid spending too much time researching and re-balancing. Like always, the choice depends on your goals and abilitiles.
You can always re-consider your trading techniques if they do not demostrate desired results over a certain time period. Consistency is important, but flexibility is also needed, given the constantly changing nature of financial markets. You can assess your own performance using basic metrics such as the total gain to loss or reward-to-volatility ratios. You could also consider the process of backtesting, which involves trying out a trading strategy using historical price data to evaluate whether it would be effective for your chosen asset. It could be assessed using common statistical metrics such as the sharpe or sortino ratio that quantify gains in relation to risks. Remeber to practice on the demo account before risking your real capital.
The last but not least aspect of your trading should be the ability to control your emotions and base trades based on reason and a planned out strategy. At the beggining of your trading process you may consider letting your profits go on and reduce your losses at earlier stages to avoid unnecessary panic.
Strategy and Risk Management in Long-term investment
Methods of risk management for investmenting are quite different than in short-term trading. Because many times investing has longer term objectives, small daily volatilities are not given as much attention. There are plenty of long-term strategies available to choose from, such as the most basic buy-and-hold or dollar-cost averaging, yet one needs to consider the risks associated with them.
Diversification is perhaps the oldest and the most basic method of risk management and involves spreading risks by investing into a variety of different assets. The aim of this strategy is not to achieve the largest possible return but rather to protect an investor from large losses. Why does diversification work? Well, simply because different industries, geographical areas and asset classes react in a different way to the same global geo-politican and economic events. There are many ways to diversify your portfolio, not only in terms of company or industry, but also in terms of size or market capitalization and geographic location. You may also choose to diversify the actual assets you are holding inside your portfolio; for instance, if you invest heavily into stocks you might consider adding in some ETFs or commodities.
Like anything else in trading this technique has a downside and what one needs is a healthy balance. Adding too many assets some of which you might not be familiar with make it difficult for you to watch every position, manage and rebalance in a timely manner. A healthy balance that will allow you to earn a profit without too much risk may be a good strategy.
There are many techniques investors employ to diversify their portfolio; one of the most famous is the Markowitz Portfolio optimization (Modern Portfolio Theory), aiming to combine assets in a way so that is has the minimum possible given a certain return. Because markets are constantly changing an investor should re-visit their positions to maintain the desired mix of assets that hedges against market volatilities. Don’t forget to plan, assess and review!
Hedging involves taking the opposite position to your trade; in basic terms, to ‘cancel’ it out by opening a trade of the opposite direction to protect yourself in case the market trend turns against you. This strategy works by reducing investor’s risk in case of opposite to desired price movements by opening an offsetting trade in a related asset. Many times hedging involves some kind of complex financial instruments such as derivatives, options and futures on the underlying assets such as stocks, commodities, bonds or currencies. However it can also be achieved by simply taking the opposite trade position, for example shorting to offset a long trade and vice versa.
How does hedging work then? Let’s say you are long 10 shares of a company A which is one of the companies in the S&P 500 index, which you buy for $10 each. The risk here comes from the possibility of the index being overvalued. Now, if you are long one asset your offsetting position needs to be of the opposite direction i.e. short; another way of heding is using a derivative such as put options, although options are complex instruments and require practice in using them. In case of shorting, you could short an ETF that tracks this S&P 500 index which contains company A. In case the market does decline and your asset falls in price, the losses on the long stock position can be covered with the profits you make from closing down your short position. A put option on the other hand would give you the right to sell the stock at a pre-determined higher price than the final lower asset price and likewise offset losses with profits from it.
Whether you should hedge at all depends on your outlook and confidence on the future performance of the assets you invested into. Hedging doesn’t prevent your trading from negative events but it does help in mitigating the resulting losses and requires careful planning. It is quite a useful technique you should consider as one of the possible options to your long-term risk management.
All of the risk and risk management techniques we have considered so far focused mostly on asset or industry specific risks. Major economic events also impose risks to your trading process; for example major economic downturns, political events such as elections,wars, sanctions or embargos increase market volatility, offer new opportunities as well as threats to your existing positions. It is important for each trader to be updated on most recent global events affecting them and eToro provides a news feed for that. You can always custom it to your own needs and preferences. You could also consider the news feed of each stock you are trading to be more specific to each asset you are trading. While building your economic calendar you may start by considering the time zone you are trading in as well well as the dates which are relevant to your positions. You then could consider the types of company, industry and economic events that affect your trades and plan accordingly to how they would impact your positions.
Hopefully this article gave you a basic idea of the kind of risk management techniques traders and investors use. The choice of how to manage your trading risks ultimately depends on your trading style and objectives, as well as the trading horizon you prefer, but there are some common factors you should certainly consider. Remember that any trading involves capital loss risks so practicing and carving a suitable strategy is key! Best of luck and enjoy trading on eToro!
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