US Election:
Risk management for election trading

US Presidential 2024: Risks and opportunities

The next US presidential election is likely to be a flashpoint for market volatility. ADSS has already shown how the policies of the two candidates may impact markets, and looked at some ways traders can respond to them. But trading, necessarily, involves risks, and those risks need to be managed. Risk management is one of the most important parts of successful trading, and not only protects traders from losses but also allows their strategies to develop rationally, expressing a market view that makes sense and can be defended with evidence. Adding a few classic risk management techniques to your trading can help you improve your win rate and overall profitability, making this election a perfect opportunity to explore financial markets.

“Risk management isn’t about avoiding risks but choosing them.”

What’s happening in the election?

Polls show a small but consistent lead for Democratic candidate Kamala Harris, but they are so close in decisive swing states that the outcome of the election remains uncertain. The Trump trade emerged over the summer, when polling indicated a slight lead for Republican Donald Trump: long US dollar and long US equities, especially energy stocks like Exxon Mobil. Some traders are unwinding this trade as polling numbers change, but with the election still too close to call these assets are likely to be volatility flash points going into November. The market impact of the US presidential election isn’t just limited to stocks and FX, with oil and gold both strongly exposed to politically driven market movements.

“If you are disciplined with preserving your risk reward ratio, it does not matter what your win rate is, so long as it matches the ratio”

Risk management for election trading

Traders looking to take positions on these assets need to understand they will be impacted by polling numbers and the election result. The Trump trade is directly linked to the electoral fortunes of the Republican candidate, and traders active in the US dollar should use their view on the election to guide their positions. If you think momentum will continue to favour Harris, then shorting the Trump trade, either through short USD positions (or long EUR/USD), or short CFD positions on the S&P500 or top US energy stocks such as Exxon Mobil, could potentially be a powerful way to express this view. But because of the inherent uncertainty of a large election, it’s important to manage the risks associated with either trade.

Stop losses

Stop losses are the most basic and important risk management tool for traders. What is a stop loss? A stop loss is an order to automatically close a position when the price of an asset falls (or in a short position, rises) to a certain level. Setting stop losses allows you to exit failed trades and minimise the associated loss, and your stop loss should always be set at a price that preserves the risk reward ratio of your trade. A common ratio is 1:2, which means the stop loss is 50% of the distance between the entry point of the trade and your expected take profit level. It is a good idea to also use automatic orders for take profit, so that you exit the trade instantly when the price reaches this level. For most traders, who use the 1:2 risk reward ratio, the take profit should be twice the level of the stop loss, so if you go long EUR/USD at 1.10 with a take profit level of 1.20, the stop loss order should be placed at 1.05.

Stop losses and win rates

Once you have made a few trades, you will be able to see your win rate. If you are disciplined with preserving your risk reward ratio, it does not matter what your win rate is, so long as it matches the ratio. It’s easy to see this with an example.

1:2 risk reward ratio, 50% win rate breakeven

Let’s say you have a technical forex trading strategy based on the RSI or another technical indicator, which over your last ten trades has a win rate of 50%. If you preserve a 1:1 risk reward ratio, with stop losses the same distance from your entry price as the take profit level, your strategy will be profit neutral. This happens because the 50% of losses equal the 50% of gains. But if you use the standard 2:1 risk reward ratio, with a stop loss half the distance from the entry price of the take profit, you can expect gains of 50%. With a 1:2 ratio, the 50% of failed trades will only equal half of the value of the 50% of successful trades. This results in a net profit of 50% compared to your initial investment.

Do stop losses affect your win rate?

Markets move up and down, so the closer your stop loss is to the entry price the more likely it will be triggered, closing the trade. That means very high risk reward ratios, such as 1:10, are much more likely to be stopped out, negatively impacting the win rate. Successful risk management in trading is about finding a balance between maintaining your win rate and your risk reward ratio. Good traders ensure the two are matched to protect profitability. If you find your win rate dropping significantly because of stop losses, especially if the market then continues to move in the direction of your original trade, consider a lower risk reward ratio, perhaps 1:1.5.

1:1.5 risk reward ratio

The 1:1.5 risk reward ratio is a less common variation of the classic 1:2, and it may be appropriate if preserving 1:2 is impacting your win rate. Returning to the EUR/USD example above, that would give a stop loss of 1.03 for the same take profit of 1.20 and entry point of 1.10. This new stop loss is two thirds of the distance from the entry point to the take profit level, instead of one half of the distance. That means it’s less likely to be stopped out by minor fluctuations in asset prices. This change could potentially improve the win rate of the trade, resulting in an improved overall return. Risk management, far from being about avoiding risk, allows you to match your stop losses and take profit levels to your style of trading and success rate.

Diversification in trading

Trading isn’t about taking out a single position because you have an idea or suspicion on a single market. Instead, view your trades as part of a portfolio of managed risks, spread across markets and across asset classes. Especially with technical analysis, many of the strategies and techniques are applicable across markets, so you can try and diversify where you trade. Within each asset class, taking out multiple, uncorrelated positions is also important. For example, if you have three active FX trades, and they all involve short USD positions – say long EUR/USD, long GBP/USD, and short USD/CAD, you are making the same trade three times. That means your risk is concentrated, and you would be much better off diversifying by trading different pairs – such as long GBP/AUD, and short NZD/CAD – to express the same view without concentrating in one trade, in this case the US dollar. For assets in the Trump trade, such as the dollar or S&P500, this is doubly important, as their price trajectory will be heavily dependent on the outcome of the election – something that is inherently unpredictable.

Conclusion: protect your portfolio, but keep trading

Risk management isn’t about avoiding risks but choosing them. The 2024 presidential election is an opportunity to get active in volatile markets, including US equities, forex, and commodities. There are many assets that could see enhanced price action in the run up to the occasion, offering more opportunities to traders to enter and exit positions. Risk management is about thinking strategically, ensuring your trades aren’t isolated but form part of a strategy, and that your position sizing and stop losses make sense. With these basic principles, you will be much more ready to start or restart your trading today and get involved in the US election financial markets.

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