Let’s say we open a position on the Euro-dollar currency pair. At present it’s worth about 1-11-25 – that’s 1 point 1-1-2-5 dollars to the Euro. As a beginner, we should be aiming to risk $1 for every $2 of potential profit. That way, the ratio between the maximum profit we can make and the maximum loss we’re liable to suffer is 2 to 1. A more experienced trader might aim for a higher profit at the same potential, let’s say 1-12-17 for a 4 to 1 ratio. 

Another risk management tool is diversification What it means is simply not concentrating on one asset but creating a portfolio where different assets react to the market differently. We’d mix low risk bonds and funds with higher risk shares and commodities. It means making less violent moves up or down, but there’s safety in caution.

Hedging is our 3rd tool – a little more complex. What we’re doing here is putting up an encloser of safety. How? Let’s say that we expect oil to go up and we open a position on oil. What will happen if it disappoints by dropping? If we were to short oil at the same time we go long, yes, we’re hedging but that’s a zero-sum game. Instead, we open our counter position on a related asset – let’s say the Canadian Dollar. Why? Well, Canada’s major export is oil, so if oil goes down the Canadian dollar goes down, but not in the same manner.

But Like we said last lesson, the most important risk factor in trading is YOU. One thing that’s common to all of us is our emotions. Fear and greed. They’re at the bottom of nearly everything we do. We over-trade from greed. We freeze from fear. A position starts losing, we panic. Instead of closing it, we wait to see if it’ll recover. It doesn’t. we wait more. Or a position gains beyond our expectations. Instead of closing it, we get greedy and it reverses.

How do we battle our emotions?
Well, greed is easy: we set down our strategies in pen and paper and mark our goals for each position. Then we stick to them. Fear isn’t quite so simple. The best way to fight it is to go back to the top of the script: know your asset. The more you know, the more control you have. The more control, the less fear.

Like trading, it’s really all quite simple…