Managing risk in breakout trading
Every trader will get things wrong at some point, no matter what the signals say. Practise proper risk management to prepare for and minimise potential loss.
As with any trading strategy, returns are not guaranteed, and risk management is crucial. Successful breakout traders carefully consider their risk tolerance and generally place limit orders and stop-loss orders. In this article, we’ll look at determining your risk tolerance and managing risk by not over-leveraging.
What is my risk tolerance?
Risk tolerance is your ability and willingness to withstand fluctuations or potential losses in the value of your trades. It’s a subjective measure and varies from person to person. Your risk tolerance will be influenced by your financial goals, trading time frames, financial situation, and personal comfort with risk.
You might be more, or less, comfortable with risk than someone else, but it’s important to think about this before you start trading, and to tailor your trading strategy accordingly.
When you’re pursuing a breakout trading strategy, your risk tolerance will determine how much of your capital you’re willing to risk on any single trade. You might want to think about this in terms of a percentage of your total trading capital. For example, if you’re trading a forex pair, you might decide that you’re willing to risk 2% of your total funds on a single trade.
You’ll use this percentage to help you set stop-loss orders. The distance between your entry point and the stop-loss level (in pips, for a forex trade) is your risk per trade.
Example
Let’s say you have $20,000 AUD in trading capital (the default amount in virtual funds you start with in an IG demo account). You decide you’re willing to risk 2% on a Forex trade, and your stop-loss order is set at 20 pips. Your risk per trade is therefore $400 AUD (2% of $20,000 AUD).
What about leverage and risk?
Leverage allows traders to control larger positions with a fraction of their own capital. But, while it can amplify profits, it also increases the risk of significant losses. It’s therefore important that you use leverage carefully and apply smart risk management strategies. This includes establishing personal rules for the maximum leverage you’re willing to use, which helps prevent impulsive decisions.
Example
Suppose you’ve got $5,000 AUD in trading capital and you’ve identified a key resistance level at 1.1500 in the EUR/USD pair. You believe that if the price breaks above this level, it could lead to a significant upward trend.
Without leverage, you could enter a trade with your entire $5,000 AUD capital. If the breakout happens as you expect and the EUR/USD moves in your favour, any profits would depend on the size of the breakout.
But, if you opted for 50:1 leverage, you could control a position size 50 times your trading capital. In this example, you could trade up to $250,000 AUD ($5,000 AUD x 50) worth of EUR/USD.
If the breakout occurs, and the EUR/USD moves in your favour, the leverage amplifies your potential profit. For example, a 2% breakout has the potential for $5,000 AUD profit (2% of $250,000 AUD).
But, if the trade goes against you, the leverage amplifies your losses. If the EUR/USD moves downward, losses would accumulate based on your leveraged position. If you don’t set a stop-loss to limit the downside, the losses could potentially exceed your total $5,000 AUD capital. So, to manage risk, you set a stop-loss order below the breakout level.
You choose to set a 1% stop-loss to limit potential losses if the breakout doesn’t happen as you’re expecting. In this case, if the trade goes against you by 1%, your loss would be $2,500 AUD.
Read more about leverage here.
5-step breakout trading checklist
If you’re ready to try out breakout trading (which is best done in a demo account so you can practise with virtual funds), here’s a five-point checklist to get you started:
- Find opportunities for breakout trades: Pick a financial market and start to look for triangles/pennants, ranges/sideways consolidations, and head and shoulders/inverse head and shoulders with clearly defined resistance and support in prices.
- Wait patiently: Only take breakout trades when prices breach clearly defined resistance or support. This may include waiting for a retest of the breakout price level.
- Plan your trade: Determine your entry point, stop-loss level, and potential target.
- Implement risk management: Always use stops. They are vital in a breakout strategy in the event of a false breakout.
- Stay objective – stick to the plan: By defining your target and stop ahead of execution, you can reduce the emotional influence of watching price action unfold in real-time. Once price targets and stops are determined, there’s no reason to risk capital (even virtual funds!) with emotional reactions.
