It is a structured approach to managing the uncertainty related to a threat through a sequence of human activities that includes the identification, analysis, and evaluation of risks. And then establish the strategies for their treatment using managerial resources. Therefore, in a random environment and with as much uncertainty as the markets are. And, where we have money at stake, it is very important to have good risk management.
What is the most important point when managing risk?
The most important thing is to limit losses in an environment where you can lose indefinitely until you go bankrupt. The use of the stop loss is very important. This placement of a stop will allow you to say at what point you are going to close the operation. This, in case it goes against you.
It is essential to use a stop loss. It can be used closer or further from the price with a greater or lesser risk to the account. But there always must be a point at which we cut in case of working without the stop loss. This, before or after the account ends up going bankrupt.
It is unavoidable, so, the placement of a stop loss is the main point. Another point to consider is if we use a fixed risk per total balance trade. That difference is the fact of using simple interest in case of always go with a compound interest. This, in case you consider the risk depending on the percentage that you risk the total account.
What’s composed interest in Risk Management?
Compound interest in risk management consists exactly in the distance between the entry and the stop loss. It defines the total loss. If you say that in each operation you are going to lose 1% of the account. Then the loss is limited there. Therefore, the parameter where the entry and the stop is the one that defines the note g and the note g is the number of lots.
Compound interest makes it smoother in the event of a bad streak and in the event of a good streak it is increased. This, since, if a transaction is lost with an account, for example, it is an account of 100 and 1 euro is lost. It is transferred to have 99. So, in the next operation we will no longer be risking 1%. But we will be risking 0.99 if we end up having a streak where the account falls by 10%. So, the point one is that you use a stop loss. Point 2 is that you apply compound interest, which is an interest rate that works very well to have a very good risk management.
What is leverage in Risk Management?
A very delicate point in trading is leverage. It consists of being able to work as if your account was much larger than the account you really have. The leverage can be 1-100, which is like if the account was a hundred times greater than the one you have.
There are many leverages, so that this weapon can allow you to win a lot. But at the same time, it is a double-edged sword that can make you lose much more until you break the account. For you to take advantage of it, you must limit losses. So, it is not a problem to use leverage if you never access a maximum of 2% risk per operation. This percentage will really depend on your strategy.
In risk management, the analysis of the back test is super important. The simulation that you have done of the strategy in the past for many years. This, to know what the worst moments are. Therefore, at the end of everything it is linked, and that placement of the stop loss is related to the back test. The back testing can give a benefit by performing it on an annual, monthly, and weekly average.
Conclusion
In this article we tell you what risk management is about and the main components for it to be applied in a better way. As always, we hope that this information can be helpful for your training as a professional trader.