Advanced risk management strategies

Developing your risk management skills

A trader’s journey in financial markets includes growth from basic skills to advanced trading methods. As a trader’s skills develop, higher level market analysis and more sophisticated trading strategies should be supported by advanced risk management. When advancing in their journey, traders will also potentially handle bigger amounts of capital, emphasising the need for smarter risk management to mitigate losses.

Advanced risk management aims to create robust risk control measures to support sustainable success in trading. The goal is to maintain a long-term trading career by minimising significant losses in various market conditions, while maximising the profits during dynamic market conditions.

Knowledge about basic risk management strategies and tools is the foundation for developing an advanced risk management approach. The concepts and tools explained in this article are advanced applications of basic risk control measures, such as stop loss orders and position sizing. Advanced risk management can also be a combination of several basic risk management rules.

It takes time to create an effective risk management approach and documenting your trading activities may help to continuously develop and improve your risk management. Journaling and back testing are not direct risk management practices, but they allow traders to build a tested and proven approach for limiting risk and maximising potential.

Assess risk with win rates, risk-reward ratios and drawdown levels

Win rates, risk-reward ratios and drawdown levels are key concepts in advanced risk management for assessing the potential risks and rewards of your positions.

A win rate refers to the portion of successful trades out of all trades, and it’s often represented as a percentage, whereas risk-reward ratio measures the potential reward of a trade against its potential risk. Drawdown levels refer to the peak-to-trough drop in the value of a trading account, and it’s a crucial measure to calculate risk and plan risk management.

Experienced traders use these concepts together to assess risk and determine their risk management rules. Their advanced risk management approach seeks to combine several basic risk management tools into one powerful strategy, in order to mitigate risk and secure the most potential profits.

Next, we’ll explore some of the commonly used tools by advanced traders.

Diversification of trading portfolio and assets

Diversification means not putting all your eggs in one basket or, in the case of online trading, not investing all your money in one asset, region or industry. A diversified portfolio is an assortment of trading products that don’t have similar correlations or behaviours.

Diversified portfolios typically leave traders less exposed to specific events that can impact a particular company or sector.  If all your money is invested in one company or industry, an unfavourable swift change in market conditions could generate significant losses.

Holding positions across various asset classes such as commodities, stocks and currency pairs forms a balanced portfolio that is more likely to withstand the potential risky conditions faced by a specific asset. With a diversified portfolio, even if some of your assets suffer losses, other assets may remain profitable. Diversification of a portfolio does not only reduce risk, but also ensures a more resilient performance while tapping into a wider range of opportunities from different sectors and geographical areas.

Scaling in (or out) of positions

Flexibility in entering positions is a tactful method of advanced risk management, as a trader considers the potential and success of a trading idea with evidence of success. If the trade idea turns out to be successful, a trader can increase the position size with the aim of making bigger profits. This strategy is called scaling in.  

For example, instead of immediately opening a gold position of a standard lot size, a trader might execute their position in small batches of mini lots. In case the market keeps moving towards the anticipated direction, the trader can keep adding these batches until the whole order is executed. In the event that the market changes direction, the entire position does not get executed and losses are experienced on a smaller scale. 

Scaling out refers to partial closure of a well-performing position to avoid a bigger rollback of profits if market conditions suddenly change. For example, a trader with an open position of 5 lots may decide to exit the trade in parts of one lot at different profit levels - leaving a percentage of the trade open in pursuit of larger profits. Scaling out reduces the risk of losing the entire position if the trend changes, but also allows the trader to chase their profit target with the remaining part of the position.

Locking in profits with a trailing stop order

Stop loss orders are familiar tools to traders of all levels. However, in advanced risk management, traders often prefer a tool called a trailing stop loss. A trailing stop loss order keeps moving if the price of an asset moves in your favour, while regular stop loss orders stay at the predetermined level until the order is executed or the position is manually closed by the trader.

One of the trailing stop strategies is to place a stop loss order at the break-even point. The break-even point is the same price at which the trader enters the position, meaning that if the stop loss is executed at the break-even level, the trader will not make or lose money. The advantage of this approach is that it can eliminate the risk of a drawdown to zero, granting the trader more peace of mind.

Advanced traders prefer trading platforms that allow automated trailing stop adjustments to protect profits and mitigate losses. Regular stop loss orders can also be manually adjusted to follow the price movement, though this requires constant monitoring of the market and quick actions. It’s key to remember that although stop loss orders are valuable tools, there is no guarantee that they’ll lock in profits or limit losses.

Risk adjustment with market volatility

Advanced risk management requires a dynamic approach depending on the market conditions. Trading strategies, choice of financial instruments, and the size of positions must be adjusted to reduce exposure to risks caused by market volatility.

Identifying high-risk conditions enables a trader to adjust their positions to reduce exposure in time. There are several factors that can cause increased volatility. Major news events or important data releases are examples of factors that can cause high volatility affecting one product or industry, hence increasing the risk involved in the open positions.

For example, the release of the US NFP report can have a significant impact on currency and equity markets, so traders holding positions in these markets might want to adjust their trade sizes to smaller or set a stop loss order with a modest risk-reward target.

It’s important to remember that mastering advanced risk management strategies and understanding key concepts is crucial for a sustainable trading journey. However, no strategy or tool is guarantee for success and you should never invest more than you can afford to lose.