Published on February 12, 2014
the CMC Markets Trading Smart Series Dealing with Risk
It is natural for new CFD traders to concentrate on strategies to select profitable positions but, while this is essential, it is just as important to plan how to deal with losses. The objective of most traders is to make consistent profits over the long term. However, it is important to recognise that longer-term trading inevitably involves losses too. No one who trades for more than a short period of time has 100% winning trades. Proudly No. 1 for CFD education Results from Investment Trends September 2010 Singapore CFD Report, based on ratings given by 8,900 investors CMC Markets | Dealing with Risk 2
Dealing with Risk Appreciate the importance of gaining control over risk. Discover the methods of dealing with risk that are within your grasp. Finding the balance Why risk management is important CFD trading can be different to long-term investing in the way you must deal with inevitable losses from time to time. After all, for an investor it may be possible to avoid cash losses by holding assets such as property or shares through bad times (often for many years) so the price initially paid is eventually recovered. It can be tempting to think that you can do without risk management if you have successful trading strategies. Why bother placing limits on your trading if you are using strategies that have worked in the past? To succeed as a trader, the size of your potential losses needs to make sense compared to the original profit potential on each new position. Without a disciplined attitude to risk and reward, it is easy to fall into the trap of holding losing positions for too long. Hoping things will turn around before eventually closing out for a large loss makes no sense if your original objective was a small profit over a few hours. Experienced traders know that even strategies that have been successful over the long term can leave you vulnerable to risks in the short to medium term. These risks include: • significant runs of consecutive losses • o ccasional large losses where prices gap through stop loss levels due to a major news event • c hanges in market circumstances which mean that you can never be certain that just because a strategy has worked in the past it will continue to work in the future For traders, long-term profit comes from a winning combination of: • • t he number of profitable trades you have compared to the number of losing trades AND t he average value of profits on each trade compared to the average value of losses. The combination of these ratios and the relationship between risk and reward is the important thing. For example, many successful traders actually have more losing than winning trades, but they make money because the average size of each loss is much smaller than their average profit. Others have a moderate average profit value compared to losses but a relatively high percentage of winning positions. Two keys to achieving a profitable combination of winning and losing trades are: 1. Successful strategies dealing with the what, when and why of the positions you take. This is sometimes referred to as your ‘trading edge’. It is important that these strategies cover not only entering new trades, but also getting out (in other words, when you will take profits and when you will cut losses). 2. Following appropriate rules covering how much risk you will take. These rules dealing with the question of ‘how much’ are usually referred to as risk or money management. In this guide, we discuss why risk management is important and suggest six things to include in your own risk rules. Without appropriate risk management, events like this can lead to: • loss of all your trading capital or more • losses that are too large given your overall financial position • h aving to close positions in your account at just the wrong time because you don’t have enough liquid funds available to cover margin • t he need for an extended period of profitable and prudent trading just to recover your losses and restore your trading capital to its original level Loss taken Gain necessary 10% 11% 15% 17% 25% 33% 30% 42% 50% 100% 75% 300% 90% 900% CMC Markets | Dealing with Risk 3
Losing more than 30% of your CFD account can lead to a major task just to recover what you have lost. After large losses, some traders resort to taking even greater risks, and this can lead to everdeepening difficulties. They again abandon their strategy, but this time by deciding not to enter profitable positions that meet their trading rules. Often this fear and excessive caution stems from the fact that traders are taking too much risk. For these reasons, risk management is essential to success even with winning strategies. To get the benefit of a winning strategy over the long term you need to be in a position to keep trading. With poor risk management, the inevitable large market move or short-term string of losses may bring your trading to a halt. You can’t avoid risk as a trader, but you also need to preserve capital to make money. A risk-managed approach to trading recognises that you are taking risk but need to limit that risk in the short term to maximise longerterm opportunity. Lack of risk management is one the most common reasons for failure. Risk management involves limiting your positions so that if a big market move or a large string of consecutive losses does happen, your overall loss will be something you can reasonably afford. It also aims to leave enough of your trading funds intact for you to recover the losses through profitable trading within a reasonable timeframe. The need for good risk management becomes all the more important when you use leverage and don’t fully fund positions. Using leverage and trading on margin can be a powerful tool. It increases the opportunity for profit because you can often afford to hold larger positions or a greater number of positions. It also has the potential to increase your return on investment, because less capital is needed to open and hold positions. However, it is important to be aware that trading on margin is a double-edged sword. It magnifies potential losses as well as potential profits. This makes it even more important to limit your exposure to large adverse market moves or larger-than-usual strings of losses. Good risk-management rules may seem to be holding you back at times. They can have the effect of reducing your profits over the short to medium term. There may be times when you are likely to think: ‘I could have made more money if I wasn’t limiting my positions because of risk management.’ This temptation to abandon prudent risk management is often greatest after a period of success. A single large trade in these circumstances can easily lose all your recent hard-won profits and more. This erratic position sizing can be another difficulty for traders who don’t use risk management. It is all too common to have a lot of successful trades with smaller positions only to find that the inevitable losses comes along just when you have decided to take on bigger positions. The knowledge that your trading is backed by a good set of risk-management rules can be a big help in avoiding the cycle of euphoria and fear that often leads to poor decision-making. Good risk management frees you to look at markets objectively and to go with the flow of the market confident in the knowledge that you have taken reasonable steps to limit the risk of large losses. 6 risk-management rules 1. Limit your trading capital The first thing to decide is how much capital you will devote to trading. Many people are investors as well as traders. For example, you may hold long-term assets such as shares or property. Trading normally refers to buying and selling seeking to profit from relatively shortterm price changes. Investing, on the other hand, involves holding assets to earn income and capital gain often over a relatively long term. It can be a good idea to plan, fund and operate your investment and trading separately, as each activity involves different approaches to strategy and risk management. The decision on how much capital to apply to trading is different for every individual, but some of the factors you may wish to consider include: • your overall financial situation and needs • your trading objectives • your tolerance for risk • your previous experience as an investor or trader. A consistent, controlled approach to trading is more likely to be successful in the long run. Gradually compounding your CFD account by leaving your profits in the account and prudently increasing your positions in line with your increased capital is a more likely path to success than overtrading in the short term. Wealth preservation should be a key consideration. It is best to limit your trading capital to an amount that you could prudently afford to lose if things go wrong. As previously discussed, this approach can have the added benefit of allowing you to trade without feeling too much pressure, and so improve your decision-making. Good risk management can also improve the quality of your trading decisions, by helping with your psychological approach to the market. Getting into a cycle of overconfidence followed by excessive caution is a common problem for traders. Trading without risk management makes this more likely. When things are going well, it is easy to start trading too much, abandoning strategy and taking large positions. Then after large losses traders can understandably become fearful. One useful technique in deciding on how much capital and risk to allocate to trading is to conduct your own stress test. Calculate the likely worst-case loss if there was a very big market move or a large string of losses at a time you have your maximum position open. Decide whether you could afford this and whether you could deal with it emotionally. Limit your trading position to something you can handle in these circumstances. CMC Markets | Dealing with Risk 4
You should also make sure you have the liquid funds available to support your planned trading activities. Even if you are comfortable with the overall risk you take, it is best to make sure you have enough funds in your CFD account, or available on short notice, to support your trading activities at all times. Finally, if you’re new to trading, it can be prudent to start in a relatively small way and plan to increase your trading activities once you have developed some experience and a track record of success. 2. Always use a stop loss order Successful trading involves balancing risk and reward. Good traders always work out where they will cut the loss on a trade before they enter it. slippage to occur on stop loss orders. Slippage can also occur where there is not enough volume to fill your stop order at the nominated price. Even though stop loss orders can sometimes be subject to slippage, they are a vital risk-management tool. It is good risk-management practice to have a stop loss order in place for every position you open. It is best to place the stop at the same time you enter the trade. The advantages of always using stop losses are: • Y ou control your risk and reduce the chance of large unexpected losses that can catch you off guard without a stop loss in place. • Y ou are using a disciplined approach to trading. Placing a stop order makes you consider where to cut losses before you enter the trade. It also reduces the temptation to ‘run’ losses in the hope of breaking even. • It helps you assess risk and reward. • Y ou can measure the profit or loss achieved on each trade against the original potential loss. This is the difference between your entry price and the original stop price. • Y ou may decide not to enter some trades if the profit potential is too small compared to the initial risk. • I t helps with time management. Stop losses are triggered automatically, meaning you don’t have to be glued to the screen monitoring your positions. The CMC trading platform is specifically designed to assist you with a risk reward approach to trading. It makes it easy to place a stop loss order at the same time you open a new position. Stop orders are used to exit positions after price moves against your position. A sell stop order is used if your opening trade was to buy and you are long the market. A sell stop order can only be set at a level that is below the current market price. If the market falls to the stop price you nominate, the order becomes a market order to sell at the next available price. Stop orders are often called stop loss orders, but they can also be used to take profits. For example, a common strategy is to move your sell stop loss higher as the market moves higher. On the CMC trading platform, this can be easily managed by applying the trailing stop function. A buy stop loss is used if your opening trade was to sell and you are short the market. A buy stop order can only be placed above the current market price. If the market rises to the stop price you have nominated, the order becomes a market order to buy at the next available price. Slippage. It is important to know that stops may be filled at a worse price than the level set in the order. Any difference between the execution price and the stop level is known as slippage. The risk of slippage means a stop loss cannot guarantee that your loss will be limited to a certain amount. One common reason for slippage is when price gaps in response to a major news event. For example, you may set a stop loss at $10.00 on XYZ company CFDs when they are trading at $10.50. If XYZ announces a profit downgrade and the price falls to $9.50 before trading again, your stop will be triggered because the price had fallen below $10.00. It then becomes a market order and is sold at the next available price. If the first price at which your volume can be executed is $9.48, your sell order would be executed at that price. In this case you would suffer slippage of 52 cents per CFD. Slippage is particularly common in shares because markets close overnight. It is not at all uncommon for shares to open quite a bit higher or lower than the previous day’s price, which makes it easy for CMC Markets | Dealing with Risk 5
Resistance Support Moving average Robyn has a strategy of entering trades when price bounces off a moving average that coincides with support or resistance. Quick position size example Total account size $10,000 In the Australia 200 index chart above, the moving average is at the same level as the previous resistance, which now forms a potential support level. Risk 2% of total account $200 Robyn’s strategy is to buy on the first close above the candle that makes a low at the moving average. Her strategy calls for cutting her loss if price falls below the support line, which is at 4111.5. She wants to place a sell stop loss order at 4111.0. Before Robyn confirms her entry order to buy at market, she sets the stop loss order on the CMC trading platform at 4111.0. The stop level appears as a red line on the chart. The difference between Australia 200 Index trading at stop loss placed at 4500 4475 equals risk 25 points $200.00 divided by 25 equals position size 8 units Once Robyn confirms her buy order, the sell stop loss order will also be automatically placed. 3. Use fixed percentage position sizing Working out where to place stop losses is an important element of your trading edge. One commonly used approach is to place stop losses at the first place at which the strategy you are following can be said to have failed. In the example above, Robyn has bought based on a strategy of entering when a correction rejects support and a moving average. She then expects an uptrend to resume. If price falls below the support line, the strategy can be said to have failed on this occasion. Robyn places her initial sell stop loss at 4111.0, which is just under the support line. Fixed percentage position sizing involves calculating the position size on each new trade so that the loss at the initial stop loss level equals a fixed percentage of the funds in your CFD account, such as 1% or 2%. For example, a trader with $10,000 in their CFD account might set the size of each new position so that the loss at the initial stop loss is no more that 2% of their capital, or $200. In the example above, Robyn has a CFD account of $20,000 and uses 1% fixed position sizing. This means she manages her risk so that if she is stopped out at 4111.0, the loss will be approximately $200. She sets her position at 11 points so that the loss at 4111 will be approximately $200, in this case $207.90. CMC Markets | Dealing with Risk 6
The CMC trading platform calculates the potential loss if price falls to the stop level you set. Using fractional position sizing you can adjust your position size even more precisely if you wish. You do not have to trade in whole units. Fixed percentage position sizing has a number of benefits: • It is a logical method of relating position size to risk. • Y our positions automatically become smaller if you suffer losses which helps to preserve your trading capital. • I t avoids erratic position sizing and the risk of having big positions when you lose but only small ones when you win. • I t provides a method of gradually increasing your position size as you make money. This can help your trading capital grow steadily while maintaining the same percentage risk levels. One of the things to consider in setting your position size percentage is how much of your trading capital you would be prepared to lose after a very large string of consecutive losses. Using 1%, you would lose 13% of your capital after 14 consecutive losses. Using 2%, you would lose 25% of your capital if you had 14 straight losses. What % of trading capital should I apply in position sizing? 5 5% 6 6% 7 7% 8 8% 9 4 4% 6% 5 7% 6 9% 7 10% 8 11% 9% 9 10 10% 11 2 3 4 2% 4% 6% 8% 5 10% 6 11% 7 13% 8 15% 13% 9 10 14% 10% 11 12 11% 13 1 2 3 4 Drawdown 4% 3 3% 1 CONSECUTIVE LOSSES 4 3% 2 2% 2.5% Drawdown 3 2% 1 CONSECUTIVE LOSSES 2 1% 2% Drawdown 1 CONSECUTIVE LOSSES 1.5% Drawdown CONSECUTIVE LOSSES 1% 3% 5% 7% 10% 5 12% 6 14% 7 16% 8 18% 17% 9 20% 10 18% 10 22% 15% 11 20% 11 24% 12 17% 12 22% 12 26% 12% 13 18% 13 23% 13 28% 14 13% 14 19% 14 25% 14 30% 15 14% 15 20% 15 26% 15 32% 16 15% 16 21% 16 28% 16 33% 17 16% 17 23% 17 29% 17 35% 18 17% 18 24% 18 30% 18 37% 19 17% 19 25% 19 32% 19 38% 20 18% 20 26% 20 33% 20 40% 21 19% 21 27% 21 35% 21 41% 22 20% 22 28% 22 36% 22 43% 4. Set an upper limit on the number or value of positions you have open at any one time This rule aims to defend your trading capital if you have positions open when there is a single adverse market event. For example, a trader using fixed percentage position sizing of 1.5% may set themselves a rule that they will not have more than 10 or perhaps 15 positions open at any one time. Assuming there is no slippage, this means their loss would be no more than 15% or 22.5% of their trading capital if they lost on all the positions. It’s up to you to set the limit that you feel is appropriate for your circumstances and trading. As discussed, company CFDs can be more vulnerable than other markets to gapping through stop loss levels because they close overnight. To manage this risk, it can pay to have a limit on the value of the total of the net long or short company CFD positions you hold at one time. CMC Markets | Dealing with Risk 7
For example, if you limit the total value of net long company CFD positions to 300% of the funds in your account, then a 7% overnight decline on all the positions would limit your loss to 21% of the funds in your account. A limit of 200% mean you lose 20% of your account if all the positions fell by 10% overnight. • C ompany CFDs in a single industry and listed on the same exchange, for example, Australian bank shares • C losely related commodities, for example, wheat, corn and soybean 5. Set an upper limit on the number of positions you have open in closely related instruments 6. Set an upper limit on total losses from a single strategy Diversification is just as important for traders as it is for investors. It is important not to have all your eggs in one basket. Many traders will use different trading strategies. It pays to draw the line on a single set of trading rules if it loses too much of your capital. You may consider having no more than two positions net long or short in closely related instruments. Net long refers to the difference between your total long and total short positions, for example, six long and four short positions means you are net long two positions. Examples of closely related instruments would include: • Foreign exchange pairs involving the same currency, for example, • EUR/USD • GBP/USD • USD/JPY One useful approach can be to set smaller limits for new strategies, but to be more tolerant with a proven strategy that you have used successfully over a long period of time and where you are familiar with its risk history, including likely number of consecutive losses and stop loss slippage. • USD/CHF • AUD/USD Self assessment Please give some thought to the following questions and take the time to calculate answers: 1. How much is your trading capital? 2. it better that your risk is greater than your reward? After Is 8 winning and 2 losing trades with $50 reward and $250 risk, would you be ahead? 3. Position sizing calculation … i. using as a risk-management example the two percent rule, and assuming trading capital of $5,000, calculate 2% of trading capital = ii. with a position at $10.20 and a stop loss at $9.95, your risk will be = iii. the number of CFDs to buy (position size) will be i divided by ii = CMC Markets | Dealing with Risk 8
The information contained herein / presentation (the “Information”) is provided strictly for informational purposes only and must not be reproduced, distributed or given to any person without the express permission of CMC Markets Singapore Pte. Ltd. (“CMC Markets”). The Information is not to be regarded as an offer, a solicitation or an invitation to deal in any investment product or an advice or a recommendation with respect to any investment product, and does not have regard to the specific investment objectives, financial situation and particular needs of any specific person. Contracts for Difference and leveraged foreign exchange trading involve the risk of sustaining substantial losses and are not suitable for all investors. You should independently consider the Information in the light of your investment objectives, financial situation and particular needs and, where necessary, consult an independent financial adviser before dealing in any investment product. Risk warning/disclosures and other important information are available at our website: www. cmcmarkets.com.sg or by contacting us at + (65) 6559 6000. CMC Markets does not warrant the accuracy, completeness, suitability, currency or reliability of the Information. CMC Markets accepts no liability for loss whatsoever arising from or in connection with the use of or reliance on the Information. It should not be assumed that any product evaluation or analysis techniques presented herein, if relied upon, will guarantee profits or gains or will not lead to losses. Any graph, chart or any device set out or referred to herein / presentation possesses inherent limitations and practical difficulties with respect to its use, and cannot, in and of itself, be used to assist any person to determine and/or to decide which investment product to buy or sell, or when to buy or sell them. Past performance is not necessarily indicative of future performance, result or trend. CMC Markets does not and shall not be deemed, and accepts no obligation, to provide advice or recommendation of any sort in relation to any investment product. CMC Markets may or may have expressed views different from the Information and all views expressed are subject to change without notice. CMC Markets reserves the right to act upon or use the Information at any time, including before its publication herein. CMC Markets Singapore Pte. Ltd. 50 Raffles Place #14-06 Singapore Land Tower Singapore 048623 T T F E 1800 559 6000 (local) +65 6559 6000 (international) +65 6559 6099 email@example.com cmcmarkets.com.sg © CMC Markets Singapore Pte. Ltd., Reg. No./UEN 200605050E. All rights reserved December 2011.
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