Trading in financial markets can be exciting and rewarding, but for novice traders – especially in a volatile environment – the risks can quickly outweigh the rewards if approached without proper preparation and caution.
Understanding these risks and implementing sound risk management strategies is essential to achieving long-term success.
Capital allocation: the first rule of trading
One of the cardinal rules of trading is to never risk money you cannot afford to lose. Novice traders often fall into the trap of allocating too much of their total available capital to short-term trading, driven by the allure of quick profits. However, overcommitting capital can lead to significant financial stress and poor decision-making.
Experts generally recommend dedicating only a small portion of total capital to trading, such as 2 per cent to 5 per cent maximum, depending on individual risk tolerance and financial goals. This conservative approach ensures that losses, if they occur, will not jeopardise overall financial stability.
From a psychological perspective, trading with money that one cannot afford to lose amplifies emotional stress, leading to irrational decisions like revenge trading or abandoning a strategy altogether. This emotional volatility often mirrors market volatility, compounding losses and creating a vicious cycle.
Behavioural biases and psychological impacts
Behavioural finance highlights several biases that traders must be wary of, including overconfidence, loss aversion, and herd mentality.
Overconfidence may lead traders to take excessive risks, believing they can consistently predict market movements. Loss aversion, on the other hand, can make traders hold on to losing positions for too long, hoping for a reversal, instead of cutting their losses early. Herd mentality often causes traders to follow market trends without proper analysis, leading to overexposure during market bubbles or sell-offs.
To mitigate these biases, traders should develop a disciplined trading plan and adhere to it, irrespective of market noise or emotional impulses. Regularly reviewing trading decisions and seeking feedback can also help in recognising and addressing behavioural pitfalls.
Risk management tools: essential safeguards
Effective risk management is the cornerstone of successful trading. Novice traders should familiarise themselves with the following tools and strategies.
Stop-loss orders: Setting a stop-loss order is crucial to limit potential losses. However, it is vital to tailor stop-loss levels to the specific characteristics of the instrument being traded. For example, a highly volatile stock may require a wider stop-loss to account for price swings, while a less volatile instrument may warrant a tighter stop.
The above reverberate on the position sizing, a too often disregarded pillar of risk management in trading. The size of a trade should be directly proportional not only to the trader’s capital and risk tolerance, but also on calculating how much of your capital to allocate to a single trade based on the perceived risk and volatility of the asset.
For instance, if you are willing to risk 2 per cent of your trading capital per trade, your position size should be adjusted to ensure this limit is not breached, even if the stop-loss is triggered.
Another often misused concept in trading, especially if short-term driven, is diversification. While it is true that spreading investments across different asset classes or instruments can reduce overall risk and relying too heavily on a single asset can lead to catastrophic losses in the event of adverse price movements, in short-term trading, we should avoid engaging in too many trades, which might make it difficult to properly implement and properly monitor the chosen strategy.
This is also linked to the necessity of a deep understanding of the instruments and the trading environment.
Before entering a live trade, it is imperative to study the instrument in detail. Different instruments have unique characteristics that affect their trading behaviour such as:
Liquidity: Instruments with low liquidity can have wider bid-ask spreads, leading to higher transaction costs and difficulty in executing trades at desired prices.
Volatility: Highly volatile instruments can offer significant profit opportunities but also come with increased risk. Understanding the average true range or standard deviation can help gauge an instrument's volatility.
Trading costs: Fees such as spreads, commissions, and overnight financing (swap) charges can eat into profits. Ensure these costs are factored into the trading plan.
Furthermore, novice traders should spend sufficient time on a demo account to familiarise themselves with the trading platform and practise executing trades. However, they must recognise that demo trading lacks the emotional intensity of live trading. The absence of real money at stake can lead to overconfidence in strategies that might not perform as well under real-world conditions.
Transitioning from a demo to a live account should involve starting with small positions to gradually acclimate to the psychological pressures of live trading.
In order to adequately manage risks, other factors must be taken into consideration, such as:
Economic and market analysis: Stay informed about macroeconomic events, earnings reports, and other market-moving news that can affect volatility.
Avoiding leverage misuse: While leverage amplifies potential gains, it also magnifies losses. Use leverage judiciously, keeping risk levels manageable.
Maintaining a trading journal: Keeping a detailed record of trades helps identify patterns, refine strategies, and avoid repeating mistakes. A trading journal should include details like entry and exit points, position size, and the rationale behind each trade.
Continuous education: Markets evolve, and so should your knowledge. Invest time in learning new trading strategies, understanding market trends, and staying updated on financial innovations.
Roberto D'Ambrosio is the chief executive of Axiory Global
