This is not investment advice. The information provided is for educational and informational purposes only and does not constitute a recommendation to buy or sell any financial product.
Managing the risks of leveraged products is one of the most important skills a stock trader can develop. The leverage that produces a 5 percent gain on a 5:1 position can produce a 5 percent loss, and the loss can be larger than the gain because of the spread, the commission, and the financing charge. The trader who manages the risk carefully can survive the losses, and the trader who survives can stay in the market long enough to capture the gains.
The main risk management techniques
The first technique is position sizing. The trader should size the position to a fixed percentage of the account, typically 1 percent to 2 percent of the account per trade. The position size is calculated as the dollar amount the trader is willing to lose, divided by the distance to the stop-loss. The trader who risks 1 percent of a €10,000 account on a trade with a 2 percent stop-loss has a position size of €5,000.
The second technique is the stop-loss. The stop-loss is an order that closes the position at a predetermined price, and the stop-loss limits the loss. The stop-loss should be placed at a level that matches the trader's risk tolerance, and the stop-loss should not be moved against the trader. The stop-loss is the trader's main tool for managing the risk of a leveraged position.
The third technique is the take-profit. The take-profit is an order that closes the position at a predetermined profit target, and the take-profit locks in the gain. The take-profit is useful for traders who want to lock in a profit target, and the take-profit is useful for traders who want to avoid giving back the gains.
The fourth technique is the diversification. The trader should spread the risk across multiple positions, multiple sectors, and multiple asset classes. The diversification reduces the impact of a single loss on the overall portfolio, and the diversification is a key tool for managing the risk of a leveraged portfolio.
Hedging the leveraged position
The first hedging technique is the stop-loss. The stop-loss is a simple hedge, and the stop-loss is the most common hedging technique. The stop-loss caps the loss at a predetermined level, and the stop-loss is easy to implement on most platforms.
The second hedging technique is the option. The trader who holds a long stock position can buy a put option on the same stock, and the put option gives the trader the right to sell at a strike price. The put option acts as an insurance policy, and the put option limits the loss on the stock position. The cost of the put option is the premium, and the premium is the maximum loss on the hedge.
The third hedging technique is the inverse ETF. The trader who holds a long position in a sector ETF can buy an inverse ETF on the same sector, and the inverse ETF rises when the sector falls. The inverse ETF is a simple hedge, and the inverse ETF is useful for short-term hedging. The inverse ETF is not a long-term hold, because the inverse ETF suffers from daily decay.
Common mistakes to avoid
The first mistake is to over-leverage. The trader who uses 20:1 leverage on a volatile stock can lose the entire deposit on a single trade. The leverage should be matched to the volatility of the underlying asset, and the leverage should be matched to the trader's risk tolerance.
The second mistake is to move the stop-loss. The trader who moves the stop-loss against the trade is giving the position more room to lose, and the trader is increasing the risk. The stop-loss should be placed at a level the trader is comfortable with, and the stop-loss should not be moved unless the trader has a new reason.
The third mistake is to ignore the financing charge. The leveraged position pays a financing charge overnight, and the financing charge adds to the cost of the trade. The trader who holds a leveraged position for weeks or months pays a significant financing charge, and the financing charge can erase the profits.
The fourth mistake is to over-trade. The trader who places many leveraged trades per day is exposed to higher transaction costs. The trader should be selective with the trades.
Building a risk management plan
The first step is to define the risk per trade. The trader should choose a fixed percentage of the account, typically 1 percent to 2 percent, and the trader should stick to the percentage on every trade. The percentage is the maximum loss the trader is willing to take on a single trade.
The second step is to define the maximum drawdown. The trader should choose a maximum drawdown, typically 10 percent to 20 percent of the account, and the trader should stop trading when the drawdown is reached. The drawdown limit protects the trader from a losing streak that erodes the account.
The third step is to define the maximum number of open positions. The trader should choose a maximum number of positions, typically 5 to 10, and the trader should not exceed the maximum. The position limit prevents the trader from over-leveraging the account.
The fourth step is to review the plan regularly. The trader should review the trades, the drawdown, and the win rate on a weekly basis, and the trader should adjust the plan if necessary. The review is a key part of the risk management process, and the review helps the trader stay disciplined.
Common questions about risk management
What is the best risk management technique? Position sizing combined with a stop-loss is the most effective technique. The two techniques are simple to implement, and the techniques cover the majority of the trading scenarios.
Can I manage the risk without a stop-loss? Yes, through options or through hedging with an inverse ETF, but the alternatives are more complex and more expensive than a simple stop-loss. The trader who does not want to use a stop-loss should consider the alternatives carefully.
How often should I review the risk management plan? The trader should review the plan on a weekly basis, and the trader should review the plan more frequently during periods of high volatility. The review should include the trades, the drawdown, the win rate, and the financing charges.
Related resources
Where to start
If you are managing the risk of leveraged products, the most useful first step is to define the risk per trade, the maximum drawdown, and the maximum number of open positions. Our broker comparison lists the brokers that offer leveraged trading and the risk management tools, which together tell you what the broker offers before you place the first leveraged trade.