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Managing trading risk
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Managing trading risk
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Risk Management and gnuTrade
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Introduction

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

Many professional traders and companies evaluate their trading risks, by looking at the volatility of a market – that is, the rate at which prices move up and down. They sometimes use a technique called Value at Risk or, VAR analysis, in which they use volatility to estimate the 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 VAR calculations in order to trade successfully, but it is important to understand how volatility can affect your money.

Volatility

Generally, in a market that is highly volatile, prices can move sharply up or down and in a short period of time. It is considered riskier to bet on such a market as your losses could be high if the prices go against you. However, if a market moves in your favour, your gains 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, but also, greater losses. Nobody can know for certain how the markets will move, so you should never trade with money you do not have or money you cannot afford to lose.

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

Let's say you buy a market at a price of 1,000 and set a stop order to sell at 950. If the price rises to say 1,100, you stand to 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 you lose is 50.

Diversification

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

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

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