Common Mistakes Made by Traders: Risk Management
Whether you are a new trader who has just opened your first online trading account or have a few months or years of experience under your belt, surprisingly we see traders make one common mistake over and over again.
Regardless if you trade Forex, Commodities, Shares, Futures, Options or any other financial product, it all comes down to having a plan, or in other words – a risk management plan.
Once you have made the decision to enter into a trade, usually based on technical or fundamental analysis, you are exposed to risk.
We are all exposed to risk in our daily lives and we take certain precautions to reduce this risk as much as possible. We fasten our seat belt before driving our car to the grocery store and we install fire alarms throughout our house.
The same logic applies to trade in the financial markets. And the good news is that you can apply a ‘seat belt’ or ‘fire alarm’ to trade as well. We call these tools ‘Stop Loss’ and ‘Take Profit’ orders.
Let’s use a simple example to demonstrate how "Stop Loss" and "Take Profit" orders can help manage your risk:
Matt is a new trader and he is looking forward to entering into his first Gold trade. Let’s say Gold is currently trading at $1,500 and Matt expects the price to rise over the next few hours or days. He sends a market order on his trading platform to buy one contract of Gold at the best price available. The trading platform confirms his purchase on the screen at $1,500 – now all Matt has to do is sit back and watch the price rise to make a profit.
But what if the price drops from the current level of $1,500? How much is Matt willing to lose on this particular trade if the market keeps trading lower? On the other hand, at what point is Matt happy to exit his trade if the market keeps going up in his favour? Two very good questions.
We can also assume that Matt is not able to watch his Gold trade 24 hours, 7 days a week. What if the Gold market makes a large move when Matt is not logged in on his trading platform?
Luckily, most trading platforms such as MT4 (Metatrader 4) can watch the market for you while you’re at work or at the dinner table.
All you have to do is select a ‘Stop Loss’ and ‘Take Profit’ price on MT4 before entering into a new trade. Let’s say Matt has decided that he is not willing to lose more than $20 on his Gold trade. In other words, if Matt entered his Gold trade at a price of $1,500, he wants to cut his losses when the Gold price drops to $1480. By selecting a ‘Stop Loss’ price of $1,480 in MT4 the trading platform will automatically send a sell order as soon as the market reaches $1,480. Matt has also decided that based on his analysis he doesn’t expect the Gold price to trade higher than $1,530. Therefore, he selects a ‘Take Profit’ price of $1,530 in MT4 to exit his trade as soon as the price is available in the market.
(Please keep in mind that the actual profit or loss of a particular trade also depends on the contract and trade size.)
So, what is the ideal level for placing Stop Loss and Take Profit orders?
The ‘Stop Loss’ and ‘Take Profit’ levels will depend on your particular trading style and time frame (Are you expecting to keep the trade open for seconds, minutes, hours or days?). For example, if you intend to keep the trade open for a few days and you place your Stop Loss price too close to your entry price (Entry Price: $1,500 / Stop Loss: $1,499.5) you will probably get stopped out rather quickly from normal daily price fluctuations. Again, you will have to find a balance between your trading style and the Stop Loss/Take Profit Levels in order to get it right.
Now that we have discussed how to exit a trade with Stop Loss and Take Profit orders, we can tell you about another great method of entering into a trade.
Let’s say Matt is watching the Gold price trading at $1,495 but he only wants to buy Gold when the price reaches $1,500 (Matt may think this is a significant level and expects the Gold price to rally once it reaches $1,500). Matt can either sit in front of his screen until the price hits $1,500 or he can let MT4 do the job for him.
All Matt has to do is select a ‘Buy Stop’ price of $1,500 and MT4 will automatically send a buy order when the price is available in the market. Easy!
Here’s a different scenario. Let’s say the Gold price is trading at $1,495 but Matt only wants to buy when the Gold price becomes cheaper and reaches $1,490. All Matt has to do is select a ‘Buy Limit’ price of $1,490 and MT4 will automatically send a buy order as soon as the price is available in the market.
So far, we have only covered scenarios where Matt expects the price of gold to rise to make a profit. However, since you are also able to make a profit when prices drop by ‘Shorting’ a product such as Gold, you can still use ‘Stop-Loss’, ‘Take Profit’, ‘Stop’, and ‘Limit’ orders to enter or exit a trade. You simply have to apply the same logic in reverse.
Here’s a quick example. The Gold price is trading at $1,500 and Matt expects the price to drop to $1,470. Matt can simply send a Sell order in MT4 to profit from a drop in the Gold price. (Yes! You can actually sell something you don’t own and make a profit when the price drops!).
And the great thing is that Matt can still set use a ‘Take Profit’ price of $1,470 to automatically exit his trade at a profit as soon as the price is available in the market. Matt can also limit his losses by selecting a ‘Stop Loss’ order. Let’s say Matt wants to cut his losses when the Gold price reaches $1,520. MT4 will automatically send a buy order (Remember, everything is in reverse when speculating on falling prices!) to get Matt out of his trade when his Stop Loss level is reached.
The key to successful long-term trading is managing your risks. Using tools such as stop and limit orders are a great way to control your risk and improve your trading returns.