Best Tips for Controlling Risk
Managing risk is one of the most, if not the most, important characteristic of a successful trader. It is not something that you develop overnight. It is important to learn all the tools at your disposal and identify which risk management tool is best in different trading scenarios. Managing position sizes, stop-loss orders, and option strategies are integral in helping to manage risk.
Stop-loss orders can set a nearly defined downside risk (additional risk in slippage), but using stop-loss orders in a volatile market often leads to getting whipped out of trades at unfortunate levels. An alternative to placing a stop order is utilizing an option or option spread where you have a defined downside risk in what you pay for the option and unlimited upside reward.
In a volatile market selecting the correct position size is important for controlling risk and determining a proper stop level. In a highly volatile market, you do not want to place a stop level too close to the market. You should take a smaller position with a wider stop. In a market featuring lower volatility, you might find it more appropriate to tighten your stop and have a larger position.
Using Stop Losses
Using a stop loss does not guarantee a maximum loss. As we just saw in February 2018, when the market moves quickly, there could be slippage from your stop-loss level, and your losses could exceed the expected worst-case scenario. That said, stop-loss orders are one of the best ways to reduce your trading risk and protect your downside.
When thinking about a trade and using stop-loss orders, also consider liquidity and the time of day your order is in the market. Many futures markets now trade around the clock but overnight markets have less liquidity. Such markets often see exaggerated moves since many traders leave stop-loss orders in the market. Rather than keeping a tight stop in the market overnight, reduce your position and widen your stop level to avoid getting whipped out of a position near the high or low of the day.
An alternative to placing a stop and risking getting whipped out of a position you like is to utilize an option spread which can cap your maximum loss while giving you the flexibility to stay in the position if the market trades at what would be your stop-loss level. We discuss different ways to utilize option strategies to reduce your market risk in the daily community live stream.