What are the risks?
Risk can be measured by uncertainty and the possibility of loss A successful trading system yields greater profits than losses in the long run However, there is a strong correlation between risk and potential profits, so that risky investments usually provide the prospect of making large profits as well Risk management is a systematic and logical approach to reducing or mitigating risks, and is called "management" because its purpose is to focus strictly on risk avoidance.
But in most cases, reducing risk will eliminate the possibility of profit due to the strong relationship that exists between them Which we mentioned earlier To be a successful trader, you need to learn the rules of risk management and strictly apply them.
Rule of two percent (2%)
For example, if you have $10 000 in your account, the 2% rule sets the maximum risk on any trade at $200, and just to confirm that this figure does not represent your trading volume, but constitutes the amount you risk on each trade.
Let's say you decide to buy a stock at $50, and place your stop loss at $48, this means that you will risk $2 per share. In this case, you may not trade more than 100 shares, because if the price reaches the stop loss level mentioned above, your total loss (100 shares * $2) will be equal to $200 which constitutes 2% of your total account size.
On the other hand, technical analysis can help determine where to place stop loss levels, which will help you reduce the risk. Finally, it should be noted that professional traders tend to use much lower risk ratios than
2%, which represents the maximum allowable risk.
Six percent rule (6%)
The 6% rule prevents you from opening a new position for the rest of the month when your total losses for the current month combined with the risk on your open positions reach 6% of your total account size.
Before entering into a trade, ask yourself: What will happen if all your trades suddenly turn against you?
If you use the 2% rule to determine stop-loss orders and the maximum amount of risk that should not be exceeded on each trade, the 6% rule would determine the maximum total loss that your account may experience.
Use of stop-loss orders
Trading without using a stop-loss order exposes your account to unlimited losses.
By measuring your potential loss based on the stop loss on all your open positions, you can determine the amount of capital at risk in each trade.
Finally, both stop loss and take profit orders should be placed when each trade is opened on your trading platform as the positions will be automatically closed when the price reaches one of those levels you set earlier.
The relationship between risk and potential profits
Before opening a trade, the trader must specify the entry level, the stop-loss order as well as the take profit level in order to be able to compare the risk with the potential profit.
The potential profits must be at least twice the size of the risk.
When calculating the probability of profit, the trader faces a strange paradox, so that the longer the position is kept open, the higher the probability of profit, because the stock can rise further after a month compared to just a week. But on the other hand, the longer a position is kept open, the higher the level of uncertainty.
In contrast, a trader can rely on technical analysis to trade fast short-term movements where several tools such as moving averages, price channels and support/resistance levels can be used to set targets.
