T2W Trading Community

Risk Exposure & Money Management

Now that we know the trading basics, we need to address the key issue of Risk Exposure. Risk Exposure is simply the maximum amount of your margin/deposit that could be lost in a trade. The FBs give you various tools that allow you to limit your losses and lock in your gains (profits). The main ones are listed below along with their use.

STOP LOSS

A stop loss does exactly what it says. It’s a price point where you want to signal a close on the trade. For instance lets say that we have opened a LONG trade on the FTSE100 (March) @ 4000 at £10 per point. Now we don't want to risk too much and we know that the FTSE isn't highly volatile, so we place the stop loss at 3950. Which would mean we would be risking a maximum of £500.

Before you start panicking and shouting at the monitor saying you don't have that kind of money. I am just using the £10 trade as an example. It can be anything from 1p to £500 per point, depending on your financial position.

What happens now with the stop loss is should the price fall to 3950 you would be what is called “stopped out” and the trade is closed for you. You are not given any warning, it is up to you to watch the market and decide to leave the stop loss in place or reduce your exposure amount e.g.: increasing the number from 3950.

Very few people actually use “stop losses” properly. Here is how some people use “stop losses” and wonder why they keep getting “stopped out” all the time. They place their trade and put a stop just a few points below their opening price. The trade amount they opened is quite high and therefore risks a considerable amount of their margin on deposit with the FB. Therefore to reduce their Risk Exposure, they have a limited stop loss. This is a common and tragic mistake, regardless of the market that is being traded.

Markets fluctuate all the time. They don't stay static and go up or down. Even indices that usually have low volatility, such as the FTSE, will fluctuate to some degree! What happens when you place a stop loss too close to your initial opening price is that you will get “stopped out” very quickly, and lose money as a result. This is what is known as 'Death by 1000 stops' as what usually happens is the trade is reopened and the same shallow stop loss placed again, to which in a few hours the trader has lost by being “stopped out”.

The sensible method is to first look at the chart for the previous week and check to see how much it fluctuates - my rule of thumb if I am unsure is to look at a Daily chart broken down into 15 minutes intervals for a day, followed by a broader hourly chart covering 1 week. We’re not looking at the massive trends, just the typical movement over a given short time. By analysing the chart ((we will go into this more in depth later) we can then see where our stops should be placed, relative to the trade we opened. The other thing is if your trade is a high trade e.g.: £10 and you can't afford to go beyond 50 point stop loss, then simply reduce your trade. It's much better to have a more flexible stop loss and a lower trade, than a high trade and a small stop loss.

Remember, if you are unsure of the volatility of the market you’re trading, first look at a 15 minute chart that covers a day, then an hourly chart that covers the week. This way you can spot the basic short-term volatility and where to place your stop loss. Most charting packages and online charts allow you to draw lines on the highs and lows of your chosen time period which will help gauge current volatility.

Since first writing this workbook the FSA in the UK have advised that many bookmakers automatically place a stop loss when you open a trade. This has some advantages, in that should you forget to put in a stop, you are automatically protected. However, with these types of accounts, sometimes there is little flexibility in moving the stop loss.

For example on some UK trades the point movement isn’t as wide as it is with some US trades. However, to lock in profit with UK trades on an account where the stop is automatically added, you have to wait until the stock has moved a considerable distance before you can move your stop in and lock in profit.

It is worth looking around the financial bookmakers that are available, as there are many of them now. More so than when I first started writing this workbook a couple of years ago. Maybe it’s because there is never such a thing as a pour bookmaker. This does make things better for everyone, in that as the market has really started to mature, more and more products become available for us to trade and the more means we have to profit. Plus with the added competition of all the other bookmakers around, we get lower spreads. So, look around before opening an account. Ideally you don’t want an account that has very little flexibility in moving the stops and has large spreads.

For instance, some of the lower end spread betting companies that allow you to trade pennies rather than pounds to begin with – these are the ones that are focussing on the beginner – have very large spreads, so be careful. Remember the spread costs you money.