Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 77% of retail investor accounts lose money when spread betting and/or trading CFDs with this provider. You should consider whether you understand how spread bets and CFDs work and whether you can afford to take the high risk of losing your money.

Trading risk management

Long-term trading inevitably involves losses and no trader can have 100% winning trades all the time. In this guide, we discuss why risk management is important to your trading strategy and offer pointers to keep in mind when planning your spread betting or CFD (contract for difference) trades within the financial markets.

What is risk management?

Risk management involves limiting your positions so that if a big market move or large string of consecutive losses does happen, your overall loss will be something you can reasonably afford. It also aims to leave enough of your trading funds intact for you to recover the losses through profitable trading within a reasonable timeframe.

Risk management is the process of measuring the size of your potential losses against the original profit potential on each new position within the financial markets, in order to succeed as a trader. Without a disciplined attitude to risk and reward, it is easy to fall into the trap of holding losing positions for too long. Hoping things will turn around before eventually closing out for a large loss makes little sense if your original objective was to make a small profit over a few hours.

Long-term trading profit can be described as a winning combination of:

The number of profitable trades compared with the number of losing trades
The average value of profits on each trade compared with the average value of losses

It is important to combine these ratios and the relationship between risk and reward. For example, many successful traders actually have more losing than winning trades, but they make money because the average size of each loss is much smaller than their average profit. Others have a moderately average profit value compared to losses but a relatively high percentage of winning positions.

Why is risk management important in trading?

Experienced traders know that even trading strategies that have been successful over the long term can leave you vulnerable to risks in the short- to medium-term, including:

Significant runs of consecutive losses
Occasional large losses where prices gap through stop loss levels, for example due to a major news event
Changes in market circumstances which mean that you can never be certain that just because a strategy has worked in the past it will continue to work in the future

Without appropriate risk management, events like this can lead to:

Loss of all your trading capital or more
Losses that are too large given your overall financial position
Having to close positions in your account at the wrong time because you don't have enough liquid funds available to cover margin
The need for an extended period of profitable and prudent trading just to recover your losses and restore your trading capital to its original level

Trading risk management calculator

Loss taken	Gain necessary
10%	11%
15%	17%
25%	33%
30%	42%
50%	100%
75%	300%
90%	900%

Loss taken
10%
15%
25%
30%
50%
75%
90%

There is still, of course, the possibility that the above scenarios can arise even after you have used the appropriate risk management strategies. Losing more than 30% of your account can lead to a major task just to recover what you have lost. After large losses, some traders resort to taking even greater risks, and this can lead to ever-deepening difficulties.

To get the benefit of a winning strategy over the long term, you need to be in a position to keep trading. With poor risk management, the inevitable large market move or short-term string of losses may bring your trading to a halt. You can't avoid risk as a trader, but you need to preserve capital to make money.

A risk-managed approach to trading recognises that you are taking risk but need to limit that risk in the short term to maximise longer-term opportunities. Lack of risk management is one of the most common reasons for failure.

Margin risk management

Margin trading is a double-edged sword, in that it magnifies potential losses as well as potential profits. This makes it even more important to limit your exposure to large adverse market moves or larger-than-usual strings of losses, in order not to trigger a margin call on your positions.

Risk management rules can sometimes reduce profits over the short to medium term. The temptation to abandon prudent risk management is often greatest after a period of success and even a single large trade in these circumstances can easily lose all your recent hard-won profits and more. It is all too common to have a lot of successful trades with smaller positions, followed by the inevitable losses that come along just when you have decided to take on bigger positions.

A consistent, controlled approach to trading is more likely to be successful in the long run. Gradually compounding your account by leaving your profits in the account and prudently increasing your positions in line with your increased capital is a more likely path to success than overtrading in the short term.

Good risk management can also improve the quality of your trading decisions, by helping with your psychological approach to the market. Getting into a cycle of overconfidence followed by excessive caution is a common problem for traders. Trading without risk management makes this more likely.