by Kathy Lien

Although risk management is one of the simpler topics to grasp, it seems to be the hardest to follow for most traders.  Too often we have seen traders turn winning positions into losing positions and solid strategies result in losses instead of profits.  Regardless of how intelligent and knowledgeable traders may be about the markets, their own psychology will cause them to lose money.  What could be the cause of this?  Are the markets really so enigmatic that few can profit?  Or is there simply a common mistake that many traders are prone to make?  The answer is the latter.  And the good news is that the problem, while it can be an emotionally and psychologically challenging one, is ultimately fairly easy to grasp and solve.

Most traders lose money simply because they have no understanding of or place no importance on risk management.  Risk management involves essentially knowing how much you are willing to risk and how much you are looking to gain.  Without a sense of risk management, most traders simply hold on to losing positions for an extremely long amount of time, but take profits on winning positions far too prematurely.  The result is a seemingly paradoxical scenario that in reality is all too common: the trader ends up having more winning positions than losing ones, but ends up with a negative profit/loss (P/L).  So, what can traders do to ensure they have solid risk management habits?  There are a few key guidelines that all traders, regardless of their strategy or what they are trading, should keep in mind.

Risk-Reward Ratio

Traders should look to establish a risk-reward ratio for every trade they place.  In other words, they should have an idea of how much they are willing to lose, and how much they are looking to gain.  Generally, the risk-reward ratio should be at least 1:2, if not more.  Having a solid risk-reward ratio can prevent traders from entering positions that ultimately are not worth the risk.

Stop-Loss Orders

Traders should also employ stop-loss orders as a way of specifying the maximum loss they are willing to accept.  By using stop-loss orders, traders can avoid the common predicament of being in a scenario where they may have many winning trades but a single loss large enough to eliminate any trace of profitability in the account.  Trailing stops to lock in profits are particularly useful.  A good habit of more successful traders is to employ the rule of moving your stop to break even as soon as your position has profited by the same amount that you initially risked through the stop order.  At the same time, some traders may also choose to close a portion of their position.

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For those looking to add to a winning position or go with a trend, the best strategy is to treat the new transaction as if it were a new trade of its own, independent of the winning position.  If you are going to add to a winning position, perform the same analysis of the chart that you would if you had no position at all.  If a trade continues to go in your favor, you can also close out part of the position while trailing your stop higher on the remaining lots that you are holding.  Try thinking about your risk and reward on each separate lot that you have bought if they are at different entry points as well.  If you buy a second lot 50 pips above your first entry point, don’t use the same stop price on both, but manage the risk on the second lot independently from the first.

Using Stop-Loss Orders to Manage Risk

Given the importance of money management to successful trading, using the stop-loss order is imperative for any trader looking to succeed in the currency market.  The stop-loss order allows traders to specify the maximum loss they are willing to accept on any given trade.  If the market reaches the rate the trader specifies in his/her stop-loss order, then the trade will be closed immediately.  As a result, using stop-loss orders allows you to know how much you are risking at the time you enter the trade.

There are two parts to successfully using a stop-loss order: (1) initially placing the stop at a reasonable level and (2) trailing the stop – meaning moving it forward toward profitability – as the trade progresses in your favor.