Introduction to Risk Management and Social Trading
A strong approach to risk management is fundamental to any consistently successful trading or investment strategy. Without a clear, defined risk management strategy there is not a trader in the world that will not come a cropper sooner or later. Being a consistently profitable investor, even a star performer, is not about not taking losing positions. It’s not even about never getting it very wrong or even necessarily taking more winning positions than losing. Consistently achieving trading profits is about earning more money from winning trades than those the trader will inevitably be wrong on.
Even the best traders lose money on trades. However, they have a clear risk management strategy to ensure that losses are limited and more than compensated by the winners. It’s oft repeated, but no less accurate, that the primary reason traders fail is that they fail to manage risk correctly. This is especially true of beginners, who often burn through initial deposits and then often give up. It is natural for beginner traders to need time to become profitable and that for some time they should expect to lose money.
However, even in this case, proper risk management will mean losses are kept within a reasonable budget. This gives the trader time to gain the experience and skill necessary to move into profit at an acceptable cost.
Even experienced traders can occasionally let the blood rush to their head and, convinced in a trade, set aside their usual risk management strategy. This is potentially to significant cost if their conviction turns out to have been misplaced. It is in every introduction-level education to trading and probably the most repeated mantra in trading and yet risk management is the golden rule most often neglected.
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The central principle of risk management is portfolio diversification. Diversification is achieved in two main ways. Firstly, by only putting a small percentage of total trading capital at risk with any single open position. Professional traders usually put this at 1%-3%. Though some may occasionally stretch to 5% on very rare occasions this would be an exception to the rule and accepted as aggressive and not ‘best practice’ risk management.
Secondly, as well as not exposing more than a maximum of 3% to any particular trade, it also makes sense to never have more than 20%-30% of trading capital exposed to any one security, or closely correlated securities. Diversifying exposure between asset classes, such as holding positions on stocks or commodities and not just forex, is also a key principle of risk management.
If trading Forex pairs, it would be wise to spread exposure between a ‘safe haven’ currency such as the yen and more ‘risk on’ currencies such as developing market currencies. Historically, if turbulence hits financial markets capital will flow out of developing market currencies into save haven currencies such as the yen. Having positions in less correlated securities means that losses sustained by any unexpected sharp movement in one group would be softened by positions in another. Gold and company shares are other uncorrelated securities that tend to move in opposite directions and can be used to diversify exposure. This is referred to as ‘hedging’.
Trading has always traditionally closely mirrored the evolution of the online world. The internet making its way into our homes was the moment trading financial markets became easily accessible to private individuals. As software and the online world has developed, online trading platforms and tools have developed along the same lines. Traders now not only have access to huge volumes of market data but also the means to process and use it in an actionable way.
The advent of the age of online social networks has also been mirrored in trading through the rise of social trading platforms. Trading specific content, opinion and discussion on an endless range of topics is shared between users of social trading platforms in much the same way as topics on social networking platforms. Traders also share their trading histories (on the platform), results and currently open trades. And, crucially, other traders can choose to replicate those trades.
Different social trading platforms work in slightly different ways but usually allow traders to either replicate a specific trade or to assign capital to a trader which is then used to replicate their own trades. Of course, the value of trades will be commensurate to the amount of capital given under management to the ‘copied’ trader and could be less or more than the value of the lead trader’s own trades. The ‘copied’ trader usually earns a commission on the value of trades made from followers’ capital under their management. This provides a strong incentive for consistently successful traders to trade on social trading networks.
Risk Management in Social Trading
Social trading approached in the right way can be a massive plus when it comes to risk management. Approached in the wrong way and it can amount to throwing risk management principles out of the window! Beginners often make the mistake of blindly entrusting all of their capital to the trading strategy of a trader that has had a recent good run. If that run turns around into a losing streak, and all the copy trader’s account capital is exposed, things could quickly end in tears. That’s not the way to go about social trading.
However, used in the right way, social trading is a great way to add additional layers of risk management for less experienced and experienced traders alike. How?
Diversification against your own trading results: even the best traders have losing streaks. Allocating a section of trading capital to copy trade one or more carefully chosen traders on a social trading platform means diversifying against one trader’s results, including your own. Hopefully when you do hit a losing streak the copied traders are doing better, softening the impact.
Diversification between securities and asset classes: even the best traders find it difficult to follow a large number of securities and asset levels in the detail required to be familiar enough with the market to trade it successfully. This limits portfolio diversity. Allocating capital to traders who specialise in different securities or asset classes to yourself is another good way to achieve superior diversification.
Use additional risk management tools provided: most social trading platforms offer risk management tools such as ‘copy stop loss’ functionality. These let traders set their own stop loss levels on copy trades so they don’t necessarily have to be the same as those of the lead trader. Take full advantage of tools off this kind where appropriate and in keeping with your own personal risk management strategy. If the trader you are copying decides to go rogue and take a particularly high-risk position you don’t necessarily have to follow and take the same level of risk exposure.
As we’ve hopefully demonstrated, risk management should always be a key consideration for traders if they have the ambition to be consistently profitable over the long term. As well as providing a great environment to learn from traders with more, or just different, experience and expertise, it is also a way to add additional layers to a good risk management strategy.