Risk management is a crucial part of successful trading. No matter how skilled you are at analysing the markets, you will experience losses — it’s inevitable. What separates long-term profitable traders from the rest is how they manage those losses and protect their capital.
Think of risk management as your trading seatbelt. It doesn’t stop you from getting into accidents, but it helps reduce the damage when they occur.
Why is Risk Management Important?
- Preservation of capital: Your trading capital is your business’s lifeblood. Once it’s gone, you’re out of the game.
- Consistency: By limiting losses, you avoid catastrophic drawdowns that derail your strategy and confidence.
- Emotional control: With a defined risk in place, you’re less likely to panic or make irrational decisions during trades.
What Are the Main Types of Risk in Trading?
- Market Risk: The risk of price movements going against your trade.
- Liquidity Risk: Not being able to enter or exit a position at your intended price.
- Leverage Risk: Using borrowed capital magnifies both gains and losses.
- Operational Risk: Mistakes such as entering the wrong position size or forgetting to set a stop-loss.
- Emotional Risk: Acting based on fear, greed, or frustration rather than your plan.
Risk vs Reward
Effective risk management means understanding your risk-to-reward ratio. This ratio compares how much you’re willing to risk on a trade to how much you aim to gain. For example, risking $100 to potentially make $300 is a 1:3 risk-reward setup.
- A positive risk-reward ratio helps ensure that even if you win fewer trades, you can still be profitable over time.
Examples of Risk Management in Action
Example 1: Emma trades with a $10,000 account and only risks 1% per trade ($100). She places a stop-loss on every trade. Even if she hits a rough patch and loses 5 trades in a row, her account is still healthy at $9,500 — allowing her to recover calmly and avoid panic.
Example 2: Jake doesn’t use a stop-loss and risks 10% of his account per trade. After just two losing trades, he’s down 20%, which affects his confidence and leads to revenge trading — often resulting in even bigger losses.
Lesson Summary
- Risk management is essential to surviving and thriving in the markets
- It protects your capital, encourages emotional discipline, and promotes consistent trading
- Traders should aim for a favourable risk-to-reward ratio on every trade
- Always know how much you’re risking before entering any position
In Lesson 4, we’ll explore the practical techniques you can use to manage risk on every trade, including stop-losses, lot sizing, and diversification.