10 Steps Of Top Risk Management In Leverage Trading
Leverage trading calls for exceptional risk management strategies in order to protect your downside which is much greater than in normal markets. While it’s true that leverage brings the possibility for windfall gains and a huge upside with a profit multiplier of up to x100, it is just as important to cover your risk of potential losses.
If you have been an active leverage trader for a while you have probably already felt the power of increased buying power and how fast a leverage position can turn from very green to very red. This is a big problem for beginners and today we are going to cover the most important tools you need to help you succeed in the leveraged markets. You can lose all your money in leverage trading but with proper risk mitigation, this should never happen.
Another common question is where you can lose more money than you invest with leverage. Yes, that is possible but only if your trading platform doesn’t support negative balance protection.
The foundation of your leveraged investment strategies should be the risk management part. It is your job as a trader to speculate in a way that protects your downside at all times. You are the only one that can prevent a disaster by making good preparations before entering the markets.
Since leverage adds an extra dimension of risk we have to be extra careful of how we position ourselves in the markets, especially as a beginner. In this guide, I will teach you some of the risks that are not commonly expressed in the trading community. Most of the time we talk about the risk of losing money on one separate trade, but as you will see there is more to be learned.
In this guide
What is risk management?
Risk management is the technique of preserving your capital while planning a trade, entering a trade, and exiting a trade. Risk is the other side of the coin that most traders look beyond because they don’t understand it and don’t know how to control it. Since we can’t have rewards without risks we have to take responsibility when trading the financial markets and be wise about how to structure a trade. The best risk managers are those who know how to control your losses in a way that they don’t hurt your investment capital.
As a trader, you will lose around 50-60% of the trades, and it is your job to minimize the harm of those losses. Remember, risk management is not about avoiding losses completely, that’s absolutely impossible. The best way to manage your risk is to prepare and analyze each individual trade and think about the worst possible outcome for this position. If your analysis tells you that this trade is too risky, you should wait for another opportunity or change your plan.
The biggest misstep beginner traders make is to forget about controlling their risk and let chance take control over the downside results. This might work out during a few lucky trades but eventually, the markets will turn sour and your position will be in heavy losses. This is where risk management comes in and takes care of the possible downside and makes it more controllable.
Another important aspect of risk management when trading with leverage is the choice of ratio. New traders should carefully choose the best leverage ratio for beginners and all crypto traders need to pick the best leverage ratio in crypto in order to not overleverage.
Understanding the risk of leverage in trading
The main risk – Leveraged trading is riskier because it enables you as a trader to open bigger positions than your total account size and therefore increases the risk of loss. For example, if you were to buy the Tesla stock at 1:2 leverage and you have deposited $1000 in your account you would now be able to buy the Tesla stock for $2000. If Tesla were to drop 20% in value over a couple of weeks, your position would lose 40% due to the 1:2 leverage ratio. This is the main risk with leveraged trading and once you understand this concept you will be in a better position to control your possible downside with proper risk management tools.
Liquidation – Leverage is also riskier because it puts your whole account in jeopardy due to the liquidation factor. Liquidation in leverage trading is a loss of all your trading capital due to losses that your margin balance could not support. Before you get liquidated your broker or exchange will give you a warning sign called the margin call that will notify you that you are running out of margin capital. Since you have opened a larger position than normal, your account will not be able to withstand losses like a normal trading account.
Unexpected losses – This is probably the reason for most of the losses and it happens because the trader does not expect how powerful leverage might be. Your position might go from break-even to a loss of -$250 in a matter of seconds if you are not careful. This usually happens to novice traders that are trying out leveraged products for the first time. The factor that puts most beginners in trouble is the factor of uncontrolled losses that spiral into huge losses.
Greed – This factor is also the cause of significant losses due to the earnings potential there is when we used borrowed funds to open exceptionally large positions. Once a trader gets the bug for profits it is difficult to steer him away from trading with large size again. It usually takes a few big losses for a novice trader to understand that this is not the way it works and the best way to use leverage for gains is to first start out with a proper plan. If you have ever lost more money than you could afford due to overtrading, then you should definitely keep reading if you want to stay in the game.
Best risk management strategies in 10 steps
Below is a list of my 10 best strategies for risk control and they hold true for any type of trading style. No matter if you are a day trader, swing trader, or position trader, these 10 steps will bring you better results thanks to more reasonable planning. Take your time and read each strategy carefully, who knows, it might just be what you need to reach the next phase in your trading journey.
1. Plan your trade
When it comes to preparing for a trade, most beginner traders fail to make a complete plan before entering the markets. “Planning maker perfect”. That’s an expression that holds very true in financial markets and no trader should enter a market without a written down plan. A full plan consists of:
- Your leverage trading strategy (entry, exit, risk/reward)
- Choice of market
- Position size
- Maximum risk tolerance
The idea of having a trading plan is to not leave out anything to chance, meaning, the amount you are willing to lose is written down already and you know what to expect from your trade. This will help you calculate your expected return on the trade to see if it fits a healthy risk and reward ratio. Since leverage boosts the output of your trades, both positively and negatively, you should count for this added risk factor of losing more money.
Crypto trader should apply their best crypto leverage trading strategy.
2. Use a stop-loss
The stop-loss will save you 99.99% of the time and I can’t stress enough the importance of always using it. The stop-loss does two important things for a trader. First of all, it controls and cuts the losses automatically. Second, it enables you to quantify your strategy by telling you the exact amount you are willing to lose on each trade. For example, if you accept to lose $25 on each trade and you add a strict stop-loss to every order, you can calculate how much you would lose if you lost 5 trades in a row.
Now, if you add your positive expectancy to this calculation you will find out how profitable your strategy is. Those who trade without a protective stop do not take responsibility for their trading and they will end up in disaster, it’s not a question of if, it’s a matter of when!
3. Calculate your margin
Your margin capital is what fuels your trades and it is your job as a trader to keep a tight grip on how much margin you allocate to each position. If you make the mistake of using too much of your margin in one single trade, for example, 70% of your margin, you might end up losing the whole 70% in one bad trade. This would put you behind several weeks or months of trading. The reason why this is such a good risk management tool is that you know how much you stand to lose on each trade and you take control over how much of your overall trading funds go into each trade
Use our leverage trading calculator to see exactly how much margin you need for each trade. See our crypto leverage trading calculator to know how much margin you need to deposit in your crypto exchange.
4. Never use crossed margin
Crossed margin is a way of trading where every single trade has access to all your margin funds in your account. This means that when you open a leveraged trade that only requires 10% of your margin, you allow this position to use the rest of your funds in case the market moves against you. Theoretically, each individual trade that you open runs the risk of depleting all your capital in case of a big loss.
Instead, always use isolated margin to allocate only a pre-set amount of margin for each position. This way you can only lose the amount of money used when the trade was opened. Beginners have a hard time figuring this out and different brokers offer different systems so make sure that you read the fingerprint before joining.
5. Position sizing is key
Your position size is what eventually will affect your total loss in case of a drawdown and it’s the oldest risk management tool in the book. If you bet the farm and things go south you can get in trouble pretty fast. This is why it’s incredibly important to not trade too large just because leverage lets you access more funds than you have ever been able to trade with.
My first big loss happened when I opened a position of $100,000 in Bitcoin. A few minutes after I opened the position I was down -3.50% which translated into a loss of $3500. That was a big chunk of my trading capital and I was stunned over how fast that market turned on me. The bottom line is that your position size controls your losses. The market will hit you with losses of 2-5% and it’s up to you to decide if you want to lose 5% with $100,000 or $10,000. Be smart and start small!
6. Determine your risk per trade
In relation to calculating your margin, determining your total risk per trade is crucial to have a positive expectancy in trading. You need to know exactly how much you are able to lose on each position in order to calculate your risk-reward ratio. Write down your total risk per trade and then calculate how many trades you can stand to lose in a row before you are wiped out. You should be able to take at least 50-100 trades before you are out of capital. If you only last 10-30 trades you are taking on too much size and it’s time to scale down.
7. Use the 1% rule
The 1% rule says that you should only risk 1% of your total investment account in one single trade and it is so effective that it will take care of almost all your risk management alone. As a trader, it’s enough to know the 1% rule and use a stop-loss for each trade to cover most of the risks. To know how much 1% of your total account balance you can use this simple calculation.
Total account balance / 100 = 1%
Example: $5000 / 100 = $50
In this example, we have a $5000 trading account and the 1% rule tells us that we can’t risk more than $50 on each trade. Now, you can open positions that are larger than $50 but you have to keep in mind to add your protective stop at a distance that only allows for a $50 loss.
8. Know your risk/reward ratio
As you level up as a trader you will find that your risk-reward ratio is one of the most important aspects of long-term growth. If you don’t know your risk-reward you can’t accurately calculate what you expect to make and lose on each trade. Once you leave these factors to chance you will sooner or later get eaten by the market.
This boils down to math and the better skewed your risk-reward is in your favor the bigger your edge is. Your risk-reward doesn’t directly make you lose less money but by being aware of this factor you can adjust the amount of money you are willing to lose in order to have a healthy long-term trading strategy that doesn’t eat from your profits.
You are either a very accurate short-term trader that nails 60-75% of your trades or you are a longer-term trader that wins 40% of the time. It doesn’t matter which kind of trader you are, you need to have a positive risk-reward profile. A short-term trader is going to make more wins but they are significantly smaller than the wins of a long-term trader. On average, a short-term trader might win $500 per trade while a long-term trader can win up to $5000 per trade. If you add too many or too large losses to this equation it’s not going to make for a healthy trading plan. Keep track of your risk-reward profile and calculate your expected return.
Related: Risk Reward Ratio Calculator
9. Choose your market wisely
It’s obvious that cryptocurrencies are more volatile than national currencies and that stocks are riskier than long-term bonds, but which market should you choose and why? There are some general guidelines for picking the right market. First of all, are you a big risk taker? Can you handle a lot of pressure? If the answer is yes, then you might be fit to trade crypto. If not, you might be better off using leverage for long-term investing in large-cap stocks for the long term.
If you are a beginner I highly recommend that you pick a market that is less volatile but still interesting. If you need to pick a cryptocurrency, choose one of the bigger coins that have lower volatility on average. This will hurt your trading account less when you lose out on a trade.
It also depends on if you are a short-term or a long-term speculator. Most short-term traders need volatility to fuel their trades in order to make a profit every day while long-term investors need to find valuable assets that will grow over time. This is an indirect risk-management tool that will save you a lot of money in the long run.
10. Negative balance protection
If you are trading forex, stocks, or cryptocurrencies on a CFD broker you absolutely must use a broker that has negative balance protection. Negative balance protection is a system that protects the trader from ever going into debt on his trading account. As this can happen with leverage it is of most importance that you always check your broker before you deposit any funds. Leverage stock trading through CFD accounts usually goes hand-in-hand with a negative balance protection system.
This is a type of “last resort” risk-management tool that will save you in the event of a total failure. When you open a large position by mistake and your internet goes down before you had the time to add a protective stop you might lose all your funds, but with negative balance protection, you will at least not go into debt with your broker. Most traders that trade forex with leverage are used to seeing the negative balance protection being highlighted on the front page as it is a very common thing for traders to get into debt with their broker.
As you are trading with negative balance protection, your leverage ratio still matters even though you can’t get liquidated. For example, the best leverage ratio for forex beginners should not exceed 1:200 for scalpers and 1:20 for swing traders.
I know several horror stories of beginner traders who have gone into debt with over $25,000 due to not using a broker that offered negative balance protection. If you could only check one feature of your next platform it would be this one!
Risk management in different leveraged products
As a trader, you should know the different risk factors of the different leveraged products available in order to better choose which one is best suited for you. Some products are less risky and could be a better choice for you seen from a risk management point of view. Take look at the list below and learn what separates our most commonly traded products for Forex, Stocks, and Cryptocurrency.
There are different ways to control your risk when you compare crypto vs forex vs stocks which has a lot to do with how the markets behave in general.
Options contracts are a type of derivatives contract but they are very straightforward when it comes to direct risk to your capital since the total risk per trade is directly limited to the premium you pay. When you buy an option you pay a premium, let’s say $150, and this is all you stand to lose if your trade were to fail.
This takes care of 100% of the risks involved when it comes to open positions and it’s almost as if you have a locked-in stop-loss order built into the contract. Options are more difficult to understand and operate but they are the top choice in terms of risk and they generally offer lower ratios of leverage.
CFD contracts are some of the riskiest products available on the leveraged trading scene. There have been many horror stories of beginner traders going into debt due to the broker lacking negative balance protection. Since CFD platforms offer almost unlimited ratios of leverage while making their own market, it can be incredibly risky for beginners with little experience. CFD platform also offers crossed leverage and this can be deadly for an account if one single trade goes bad.
Crossed margin, as described earlier in this article, is a mechanic that enables one single position to access all your margin capital in your account. This means that one single trade can liquidate your entire portfolio. To read more on how to choose leverage ratios, read our guide on the correct leverage ratio for a beginner.
Derivatives trading such as futures, perpetuals, and swap contracts also carries a high risk but not as much as CFDs. Derivatives are contracts that derive their value from an underlying asset and are generally accompanied by high levels of leverage. Most derivatives give you an option to buy or sell a contract at a future price with an expiration time, for example, futures contracts.
This gives your trade a limited amount of risk seen to how long the position can stay open. However, derivatives contracts such as perpetual swaps have no expiration date which is seen as riskier. The level of leverage offered is similar to CFDs and since derivatives are traded on a broker you don’t really know how reliable the counterparty is.
Many derivatives contracts have been shut down due to low liquidity or because a company has gone bankrupt and this is what makes these contracts unreliable.
Derivatives are famous for offering up to 100x leverage in crypto and other asset classes.
ETFs, or Exchange Traded Funds, are among the less risky leveraged contracts you can find. They are normally traded on a big stock exchange and carry lower levels of leverage, usually at a maximum of 1:10. ETFs are supported and backed up by large liquidity providers and they are normally seen as a more sophisticated way of investing in a stock, bond, stock index, or commodity.
ETFs are a type of fund with the exception of being very easy to buy and sell. Most mutual funds have a set schedule for when investors can buy or sell, typically once per month or once per week, but ETFs can be bought or sold on an intraday basis. This reduces the risk of exposure further and is a great choice for beginner investors who are looking for leverage to add to their long-term bets.
What other traders ask about risk management
There are a couple of good techniques to control your exposure in the market. Below is a list of the three best tips:
2. Calculate your margin
3 Don’t use crossed margin
The added risk factor on leveraged trades is the added buying power that traders get access to. This creates larger swings in both positive and negative directions of your account and if you are not careful, one single trade can wipe you out if you use too much leverage.
Yes, it does. The more leverage you use the riskier it is to enter the market. A bigger position always carries more risk than a smaller and when you are wrong you will take a bigger hit to your overall account.
Depending on how much leverage you use and how big your position is, you can lose anything from 1% of your total account up to 100% of your account. Always select a ratio that you are comfortable with and don’t overdo it.
To calculate your total stake per trade you need to know how to calculate your margin used per trade. Check out our guide on how to calculate leverage to learn exactly how to do it.
First of all, read this guide to get a good understanding of what all the risks are. Then, start by incorporating all the tips and techniques I’ve listed above. Once this is done you will have a proper strategy for how to manage your trade.
If you are a beginner I would not use more than a 1:10 ratio. Those of you who are already familiar with leverage and have some years of experience could bump up the ratios to a maximum of 1:25. More than this is not really necessary since the risk of liquidation will be too significant and it will not make up for the profits you stand to make.
This has been an educational guide on how to do risk management in leverage trading where I’ve gone in-depth on some of the more commonly known risks but also some of the more subtle risk factors that new traders might not know about.
As a trader, it’s your job to make sure that you have full control over your possible downside and you don’t want to leave anything to chance.
If you follow my tips in this guide you are more likely to stay in the game for the long term and make sure that you choose a product that suits your style of trading.
To be different and level up as a trader you need to take responsibility for all the actions you take and all the actions that you don’t take. Be different, and be aware of the risks!