Trading Risk Management

Once you understand how the financial marketswork, it’s important to learn about the risks to your money and ways tominimise these risks when you start to trade.

Many professional traders and companiesevaluate their trading risks, by looking at the volatility of a market – thatis, the rate at which prices move up and down. They sometimes use a techniquecalled Value at Risk or, VAR analysis, in which they use volatility to estimatethe maximum amount of money they could lose on a given day. With this in mind,they trade in a way that limits their risks.

It is not necessary to carry out complex VARcalculations in order to trade successfully, but it is important to understandhow volatility can affect your money.

Volatility

Generally, in a market that is highlyvolatile, prices can move sharply up or down and in a short period of time. Itis considered riskier to bet on such a market as your losses could be high ifthe prices go against you. However, if a market moves in your favour, yourgains could be higher than if you put the same money on a less volatile market.In short, riskier trades have the potential to provide greater rewards, butalso, greater losses. Nobody can know for certain how the markets will move, soyou should never trade with money you do not have or money you cannot afford tolose.

A good way to minimise the amount of money youcould lose on a trade, is to use a stop order. This means, you state the priceat which the trade should automatically close if the market goes against you.

Let's say you buy a market at a price of 1,000and set a stop order to sell at 950. If the price rises to say 1,100, you standto make a profit of 100 when you sell. But if the price goes down unexpectedly,to 950 or lower, the trade automatically closes at 950, and the maximum youlose is 50.

Diversification

Diversification is another way to reduce yourrisks. Instead of putting all your money on a single trade, if you spread yourmoney on a number of trades, it may be less risky. Some traders reduce theirrisk by combining trades. Let's look at an example concerning the Nasdaq andS&P markets in the United States. These markets tend to be correlated.

On a particular day, Larry Barton believes theprice of NASDAQ will go up higher than the price of other markets in the US. Hedecides to buy the NASDAQ, but he also sells the S&P, betting that thismarket will go down. In other words he combines a long position on the NASDAQwith a short position on S&P. While he expects NASDAQ to outperform theother markets, he is protecting himself against the risk of a dramatic fall inboth these markets.

The past performance of a market does notguarantee its future results. You may find it useful, however, to track amarket for a while and get a feel for its volatility. This may help youidentify trends and decide how much money you are willing to risk. Also, it isa good idea to start trading with systems that use play money. This will helpyou gain confidence and develop your trading style without any risks. When youare ready to trade with real money, it is always advisable to bet with smallamounts, and with money you can afford to lose if the markets do not move asyou expect.