Basic knowledge of risk management

Basic knowledge of risk management

Every investment is subject to risk due to potential unfavorable price changes. As the financial markets constitute a complex system with many factors influencing the demand and supply at the same time, it is important to know that the result of practically any given transaction is uncertain.

Risk management depends very much on the types of assets the trader is interested in. In this text we would like to discuss the tools that can be used in order to minimize potential losses resulting from adverse price changes:

• study the different types of assets
• plan your strategy
• establish the maximum acceptable risk
• use the different order types.

 

Study the different types of assets

It is crucial to first understand the liquidity.

 

Depending on the type of asset you are interested in, there may be more or less volatility related. The higher  the volatility, the higher the financial risk associated with the given market. This means that operating on a such market involves potentially higher profits and losses than in the case of markets with lower volatility. There are markets where there is not much movement, while others change very often and the price changes may be quite significant.

 

Another important issue is the spread - i.e. the difference between the ask price and bid price. Different assets have different spreads, as the spread size depends on such factors as liquidity of the market, its volatility or time of the day. As the spread represents an indirect cost of the transaction for  a trader, it can be related to the volatility in order to compare the cost of transaction between the given markets. For example, the cost of operating on  a market where the spread is 4 points and the difference between daily maximum and minimum is equal to 60 points, can be considered to be more attractive than in the case of a market where the spread is 2 points, but the daily price range is just 20 points.

Plan your strategy

It is imperative to decide what type of investment strategy is to be implemented

 

The strategy shall define the key aspects of the trades, including their time horizon. There are assets where it is difficult to trade in the short term, as the cost of transaction is relatively high in relation to the size of  typical price movements. However, it is still possible to consider such markets for the purposes of investment in the longer term, cost carry transactions or possible arbitrage. On the other hand, assets that change very often could provide a good possibility for transactions in the short and ultra short term.

 

 

Establish the maximum acceptable risk for an investment or trade

 Important step that many investors seem to ignore

 

It may be a good idea to establish a maximum amount of money that he/she is willing to risk in any given transaction. Such an amount can be defined as a percentage of the available capital. Considering an example where the trader is willing to risk no more than 3% of the portfolio, 3% of that amount would mean that the investor is willing to “risk” no more than $300 USD in a trade.

 

The limit calculated as shown above, or using any other method, can be taken into account when considering where to set the stop loss or close the transaction by any other means. In order to do that, one should also consider a value of  pips. Assuming that for a specific asset the pips value is equal to $10 USD, and the acceptable risk is $300 USD, then a trader may consider placing a stop-loss with a value of 300/10 = 30 pips from the level where the transaction  was opened.

 

Use the different orders.

Understanding the possibilities behind the pending orders of the trading platform may contribute to more efficient trading plan

 

There are many different orders available at the MT5, which can potentially help to realise profits or limit the losses during the investment process:

• Market orders - buy/sell
• Stop loss
• Take profit

 

Market orders (or instant execution orders): these are simply orders (buy or sell) that are executed instantly  at the  time they are placed.

 

Stop-loss: stop-loss orders are additional orders available for both pending orders and market orders. They can also be attached to already opened positions on  a given market. These types of orders are the most basic orders designated for limiting the potential losses, for  example when an investor is not able to follow prices all the time. A trader establishes stop-loss levels by either specifying the level in points from the current price or by specifying an exact price level. For long positions, the stop-loss value must be lower than the current price. For short positions, the stop-loss value must be higher than the current price.

 

Take-profit: Take profit is an additional order available for both pending orders and market orders. They can also be attached to already opened positions on  a given market. The difference between this order and the stop-loss order is that in the take-profit order, a trader will fix the exact profit he wants to realise. Sometimes, investors are not actually sure how much a price will continue its direction, so they fix a value for which a profit is guaranteed if the price reaches that level. For long positions, the take-profit level must be above the current price. For short positions, the take-profit level must be lower than the current price. 

 

Pending orders: Pending orders will be placed immediately but executed only when the price has reached a previously determined price. There are six types of
orders available as pending orders:

• Buy limit
• Sell limit
• Buy stop
• Sell stop
• Buy stop limit
• Sell stop limit

Buy limit: an investor is willing to buy an asset when the price has reached a certain level.  At the  time of placing of  an order the market price must be higher than the one specified as the buy limit price. In this situation, investors believe that prices will fall to a certain level and will later rise.

 

Sell limit: an investor in this case is willing to sell an asset when the price has reached a specified level. At the  time of placing  an order, the market price must be lower than the one specified by the investor (sell limit price). This approach reflects the belief of the trader that prices will reach a certain level (the sell limit price level) and then start falling.

 

Buy stop: by placing a buy stop order an investor expects that if prices reach a certain level (buy stop price), they will keep on rising. The price at which the transaction  is concluded will be less favourable than the current market price. However , the fact of reaching that level could be interpreted as a confirmation signal. Once executed, this order will buy an asset after reaching a level defined by the investor. The market price at the time of placing the order must be lower than the defined buy stop level.

 

Sell stop: by placing a sell stop order a trader expects the prices to keep on falling, once a certain level (sell stop price) below the current market price  is reached. Reaching this level can also be interpreted as a confirmation order of the investor’s prediction. Once executed, this order will sell an asset after reaching a level previously established by the trader. The market price at the time of placing the order must be higher than the defined sell stop level.

 

Buy stop limit: It is combines both buy stop and buy limit features. This order will place a pending order (buy limit order) only if the price previously reaches a defined price by the investor. One may say that this is a conditional pending order, that will only be executed when the price reaches a certain level. To place this order the current price must be lower than the conditional price level - i.e. the price which activates the pending order.

 

Sell stop limit: This is a conditional pending order. An order will be placed if and only if a price reaches a price level previously defined by the investor. To place this conditional order, the current market price level must be higher than the conditional price. Once  prices start falling and reach the conditional price level a new sell limit order will be placed.