Effective Risk Management

Trading Guide 1

Contents

Introduction
Risk Warning

3 4 5 6 7 8 9

Insufficient Risk Management Understanding Risk Risk Management

the Lifeblood of any Trader

Position sizing
Two percent rule

Support resistance Exit strategy

Step 1 Stop Loss Step 2 - Take Profit Breakout strategy

Calculating Margin
How to calculate your total exposure

11 12

Control your leverage

CMC MARKETS Effective Risk Management

Introduction

Before you start it is important to ensure that you are aware of the risks associated with spread betting. Please take a minute to view the risk warning and disclaimer below before proceeding.

Risk Warning
Spread Betting is a leveraged product and carries a high level of risk to your capital and it is possible to lose more than your initial investment. Only speculate with money you can afford to lose. These products may not be suitable for all investors, therefore you must fully understand the risks involved, and seek independent advice if necessary. CMC Spreadbet Plc is authorised and regulated by the Financial Services Authority. Please remember CMC Markets provides an execution-only service. This material is for general information only and is not intended to provide trading or investment advice or any personal recommendations.

CMC MARKETS Effective Risk Management

Insufficient risk management

A common mistake that people often make is that they dont apply Strategy, Methodology and Record Keeping to their trades. Too many people enter trades without adequately thinking of what they want to achieve out of that position. By minimising risk, you can prevent a substantial loss, ultimately affecting the preservation of your trading capital. Within this PDF, we will go through how and when to place a stop loss and how much risk you should be placing on your trades. We will also discuss another common mistake that people make which is over leverage.

Trader Tip:

Having a trading plan, a trading journal and a risk management plan helps to stabilise your trading decisions with a logic that can be recorded, assessed and continually improved on. Craig Inglis

CMC MARKETS Effective Risk Management

Understanding risk

Regardless of market conditions, you still need to take a very active approach to the way you manage the risks associated with trading. Its a fact of life that even the most gifted traders have to face the possibility of making a loss. Its important for all traders to be realistic and put a risk management strategy in place at the earliest opportunity. Whilst picking the right product is important, no trader gets it right 100% of the time so it is the preservation of capital that is the most valuable lesson to learn. When people first start trading they enter trades for the excitement value and the prospect of making a nice return on their money. However, many new traders ignore the inherent risks and how to manage these risks. Some products are particularly volatile and this is where the requirement for good risk management becomes even more important. Example of a highly volatile product chart

Trader Tip:

Too much focus on the upside, with little regard for an exit strategy on the downside means you dont know when to exit and preserve your capital. Michael Hewson

CMC MARKETS Effective Risk Management

Risk management

The Lifeblood of any Trader

If you dont know where your stop will go then how many pounds per point should you trade? Most position sizing methods require you to know the answer to both without knowing this you cant apply consistent risk management to your positions. Learn to be mechanical in your approach to placing stop losses and ensure you place them on every trade you perform. By not having a mechanical approach to stop losses, it will allow your heart to take over. The want for a product price to turn around and be profitable leads to bigger and bigger losses in downward markets, making it harder to get out of the trade. This can lead to being in a trade far longer than you should be, or want to be. This is also an ineffective use of your capital.

The other advantage of stop losses is that they allow you to easily determine how much capital to place on each trade - this is known as risk to reward. There are numerous different strategies that you can use to place more effective stop losses, giving you a greater chance of a successful trade, without having to risk a disproportionate amount on one trade. Note:

Our next generation spread betting platform lets you place your stop loss based on the approximate amount of money that you are prepared to lose or based on a target price. You can also set a default stop loss based on margin requirement.

CMC MARKETS Effective Risk Management

Position sizing

Risk Management comes down to both where we place our stops and how much we place on each individual trade, and this is known as position sizing. There are several position sizing models available and they determine your risk based on either a fixed pound amount or a fixed percentage. One of the most popular methods is to risk only 2% of your trading capital on any one trade. Not only does this mean you are risking a very small amount per trade, relative to your trading account, but it allows you to place 5 or 6 trades and never have more than 10-15% of your trading capital at risk at any one time.

Two percent rule

Risking no more than 2% of your total capital per trade is a standard starting point when setting up your risk management plan. Many professional traders believe even this is too much - youll need to decide what is right for you.

2% per trade risk formula Account size x 2% = risk amount per trade 10,000 x 2% = 200 amount per trade

Your system would need to produce more winners than losers. You would need 60% winners. This has nothing to do with leverage, as you can use leverage and still stay within 2% equity of your account.

The 80/20 rule

The Pareto principle is also called the 80/20 rule. This states that 80% of your profit will come from 20% of your trades, but that you need to protect your capital so that you can take advantage of these opportunities when they arise.

CMC MARKETS Effective Risk Management

Support resistance

The concept of support and resistance is central to helping us understand market price movements when studying charts. In order to ascertain trends (the basis of Technical Analysis) we need to identify key highs and lows in price. A resistance level is an area higher than the current market price where the selling is strong enough to overcome the buying pressure creating a peak or high. A support level is the opposite of resistance and is an area lower than the current market price where the buying is strong enough to overcome the selling pressure creating a trough of low.

On the above chart we have placed a Support level (yellow line) at the key significant market lows. As the market approaches this level we have two main options. A) History will repeat itself and price will start to rise. B) We think that fundamental news will override the support level and price will break through this level and head lower. For this example lets say we believe that history will repeat itself (A), and we will base our trading decision on this. We therefore place an order to buy just above the support level (blue triangle). Please note: our charts and charting tools are provided solely for information purposes and must not be relied upon as trading or investment advice or a personal recommendation.

CMC MARKETS Effective Risk Management

Exit strategy

Step 1 Stop Loss

As the most important risk management tool available to clients, it is important to limit your risk by placing a stop loss. CMC Markets suggest one for you (only available on our next generation platform) when you first place a trade at the margin requirement for the trade, this can be altered to a new level if desired. In this scenario we will place the stop loss (red line) just below the support level (yellow line) as we believe that if the price breaks through this level it will continue to go down and we want to limit any potential losses. Another option is to place a trailing stop* at this level, this new order type will still offer protection against the markets moving against you, but will also rise if the market moves in your favour, effectively locking in some of that movement.

Step 2 Take Profit

In many cases it is just as important to set a clear defined take profit level. You can use support and resistance levels to help you determine where that price might be. In this example we have also placed a resistance level on the chart and as we now know this could be an area where sellers enter the market. Therefore we want to place a Take Profit Order (green line) to close out this trade just below this Resistance level to lock in our profit.

* Trailing Stops are only available on our next generation platform.

CMC MARKETS Effective Risk Management

Breakout Strategy
For those of you more familiar in the field of technical analysis, you can also have buy signals when the price breaks out of a resistance level. You can enter a buy trade just above this price (blue triangle), we do this as we are waiting for confirmation of change in trend, and a significant break is enough confirmation. Taking on board what we have just learnt, we look for possible support areas that could provide us with the perfect place to position our stop loss. Remember, our next generation deal ticket will show you how much (in points or value) you stand to lose if the price is stopped out. If you class yourself as risk averse or you lack the confidence in the upside movement, you could place your stop just above the first support level. If you regard this price as too close you could decide to place your stop loss at the second support level, though you are now risking more. Options here are to lower your total stake size to cater for the bigger stop loss position. Therefore we are risking the same amount on both.

CMC MARKETS Effective Risk Management

10

Over leverage

Understanding Margin
Spread Betting allows extraordinary flexibility because of the ability to trade a very diverse range of products from the long side and the short side. A big part of this comes from the use of margin which allows you to trade these positions but without having to put up the full value of your exposure. Spread betting on the likes of Indices and Foreign Exchange require a very small margin requirement of 100 to 1, meaning a 100 deposit can give you access to 10,000 worth of the underlying product. Although this gives us greater access to the markets, it also increases the risks if markets move against you.

CMC MARKETS Effective Risk Management

11

Calculating margin

How to calculate your total exposure

Multiply the product price by your chosen bet size. For example, if the share price of a stock is 99.00/100.00 and you wish to go long (buy) at 10 per point, what would your exposure be? 100.00 x 10 = 1000 exposure. Total: 5% margin (Stock ABC) 1000 x 5% = 50

What are Close-Out levels? Close-Out levels (or liquidation levels as theyre referred to on our Marketmaker platform) are levels on your account that will cause your existing positions to be automatically reduced or closed out. These levels are to provide our clients with extra protection against adverse price movements. It is important to make sure you keep an active eye on your account at all times to ensure your account is in order. If further market movements occur and you are significantly overtrading, CMC Markets reserves the right to close out (liquidate) your position(s) without warning to try and protect you from further losses. Wed like to remind you that you should not rely on our right to liquidate your position to protect you from going into deficit. Therefore you should consider using Stop Loss orders to manage your risk.

CMC MARKETS Effective Risk Management

12

Control your leverage

You should consider placing a threshold on the maximum leverage that you apply to your capital. In order to remain relatively conservative a limit of 3x leverage may be appropriate. This would mean that if you had 10,000 in your account then you wouldnt take on more than 30,000 worth of market exposure.

Note

We learnt earlier (Insufficient Risk Management) about placing stop losses at previous significant price levels. These support areas limit our losses in price, though if our market exposure is large the loss can still be quite significant. For example a stop loss at 25 pence equates to a loss of 2,500 when the exposure is 10,000. If the exposure was 5,000 the stop loss of 25 pence would lead to only a 1,250 loss.

Trader Tip:

Your stop losses are very important but if there is a sudden move in the market, a conservative amount of market exposure can be of even greater importance to you. Ashraf Laidi

CMC MARKETS Effective Risk Management

13

CMC Spreadbet plc 133 Houndsditch London EC3A 7BX United Kingdom Freephone 0800 0933 633

Tel Fax Email Web

+44 (0)20 7170 8200 +44 (0)20 7170 8498 info@[Link] [Link]

Registered Number 02589529