How To Minimize Trading Risks With Stop Losses – Part 1

How To Minimize Trading Risks With Stop Losses

Like any other financial instrument, trading is also game of managing risks. When we put our money into a process to gain profits, there are risks associated with it. Managing this risks the biggest part of trading.

Risk Taking

I trading, traders use stop loss levels to limit their risk exposure in a particular position. However at time we have opportunities which demand extra bit of risk for a major gain. Depending on what is their in our individual trading plans, we usually have few options:

  1. Pass that trading opportunity
  2. Manage risk by either taking an entry at a better level in our favour or placing optimal stop loss levels.

However in certain cases optimal stop losses can not be determined. This series of posts on How To Minimize Trading Risks With Stop Losses is about how to manage risks in these conditions.

Method 1: (Limit Trade Risk By Reducing Position Size)

Lets say I trade with one contract and you have set risk appetite of 50 pips in my trading plan. The trading opportunity that I have demands for 60 pips. I can reduce my position size from 1 lot to a lower contract size to reduce my exposure in that trade.

However this method has one disadvantage. If lets say I was supposed to gain 120 pips in the trade and my trade was successful, I will not profit as much as I could. The over all dollar (cash) profit will be smaller because of reduced position size.

Method 2: (Take a Better Trading Entry in Our Favour To Reduce Risk)

Lets say I want to short a currency pair. It is demanding 60 pips of risk instead of my usual 50 pips risk appetite because I trade with 1 lot. I do not want to follow the method 1 above as it does not give me good dollar profit in my bank.

In such cases, I can wait for the market to come into the zone and wait for a confirmation. Because the price is already there in my risk zone against me, I can take a better entry reducing my overall risk. My stop loss level will still be there where I planned but because I entered the trade late, I will have lower risk.

Wait For Confirmation To Get A Better Entry Price And Reduce Risk Exposure
Wait For Confirmation To Get A Better Entry Price And Reduce Risk Exposure

This method also comes with its disadvantages. The price may just touch the zone and start moving immediately. So I may never get a chance to be in the trade as I planned. It may also never come deep enough into the zone to give me better risk profile that I was looking for.

Method 3: (Adding to Trade Position To Average Down Overall Risk)

Traders also call it Zoning or Average Down/Up or Adding to Position.

This method works with Method 1 and Method 2 above. Initially I will reduce my position size to ensure that I have lower risk profile on the trade but have a guaranteed entry.

Once I have trade running and if it comes deeper in to my zone against me, I will wait for a confirmation and take another trade to average down my overall position. This averages down my overall risk exposure because I took second part of trade at a better price level.

Average Down Your Risks With Multiple Trade Positions Inside The Zone
Average Down Your Risks With Multiple Trade Positions Inside The Zone

This method is only effective if your average of multiple positions is actually reducing risks/reward ratio. So it is essential to set entry levels and position sizes in advance.

Of course as it has few characteristics of Method 2, it comes with disadvantages of Method 2 too. However it comes with advantage of being in the trade of Method 1.

Method 4: (Tail Stops To Actively Reduce Risk)

This method is a very common method and is used by a lot of traders to protect their profits as well as their overall risks. We can use it in conjunction with any methods mentioned above.

I can take an initial position in a trade depending what method I used for my entry. I also have an initial stop loss level set. Once I am in the position, and the price action has started moving in my favour, I start moving my stop loss level too. Moving stop loss level is usually done in certain conditions only. (Moving stop loss levels when trade is going against us, is strongly discouraged as it increases your risk exposure.)

These conditions are:

  1. If the price action has reached our predefined target I can take part of my profits and move stop loss level to a break even position. This allows to me have no loss (break even) if the trade reverses and goes against me.
  2. If the price action goes in my favour and creates a new zone where I can safely my put my new stop level. For example, in a short position if my initial stop loss level above previous swing’/structure high, I can move it a new swing high/structure if price action has created that for me. This allows me to have much safer risk exposure.
Move Stop Loss Level To Reduce Risk Exposure In Trading Position
Move Stop Loss Level To Reduce Risk Exposure In Trading Position

More to come on this series of managing trading risks. Please feel free to leave me a comment or your ideas. I would love to hear from your experiences and techniques.

Have a great trading time.

-Trade Yodha

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