We have talked a lot about risk management in this article, and that is because it is incredibly important. Even the best trader with the best trading strategy is doomed to blow through his account if he uses poor risk management.
A friend of mine plays poker for a living, and we had a long discussion about risk management a few months back. I will let him tell this story:
“I can’t tell you how many times I’ve busted my bankroll because I failed at money management, especially in my youth. Everyone is susceptible to swings, good and bad, and if you do not prepare for the downswings, you will eventually lose everything. It took me a long time to learn that. I would think that I could just depend on my skill, assuming I would always be able to beat my opponents, but even skill-based games like poker involve incredible variance. I used to be the type of guy that would put everything he had on the table. Now, I will never risk more than 1% of my bankroll in one sitting.”
The same concept applies to trading. Our goal in trading is to always take the highest probability trades, just like the goal in poker is to take the highest probability gambles. But we are still talking about probability, and that means that sometimes, even in what seem like the best situations, we are going to lose. It is inevitable.
The only way for us to stomach the losing is to prepare for it. These are the rules I follow in order to do that:
Preserve your capital and manage your money.
This is the cornerstone of trading—you should always be planning for a worst case scenario. Before asking “how much can I make?” you should ask “how much can I lose?” This is astute trading risk management. A smart businessman only takes risks that will not put him out of business even if he makes several mistakes in a row.
Define your risk.
As a trader, you are in the business of trading. You need to define your risk—the maximum amount of money you will risk, or lose, on any single trade. This is defined as a percentage of your portfolio. Most traders will risk between .5 % and 2% on a single trade. I personally do not like to risk more than 1% of my portfolio on any trade but that does not mean 1% is the magic number. It is important to note that risk and position size are two different subjects. If you have a $30,000.00 account and you are willing to risk 1% or $300.00 per trade that does not mean you will only buy $300.00 worth of stock. You could trade $10,000.00 and risk $300.00 or you could trade $30,000.00 and still risk only $300.00. Your risk is the amount you will lose if the trade goes against you.
Be aware of emotional trading.
Trading is so exciting that it often makes traders feel high, and then suddenly very down. Nobody can get high and make money at the same time. Emotional trading is the enemy of success. Fear and greed are bound to destroy a trader. A real professional trader does not get too excited or upset about wins or losses. This is proper psychology, both for trading and for maintaining a healthy, enjoyable life, hopefully with a few profits from trading, but worthwhile enough even if one happens to have losses.
Focus on being a winner, not a loser.
The goal of a successful professional in any field is to reach his personal best. To be a winner, you need to concentrate on trading the right way. Each trade has to be handled like a surgical procedure—seriously, soberly, without sloppiness or shortcuts. This is a trading risk management plan, not a trip to the casino.
A loser struggles to cut his losses quickly. When a trade starts going sour, he hopes and hangs on, and his losses start piling up. And as soon as he gets out of a trade, the market comes roaring back.
Trends reverse when they do because most losers are alike. They act on their gut feeling, instead of using their heads. The emotions of people are similar, regardless of their cultural background or educational levels.
Emotional traders go into risky gambles to avoid taking certain losses. It is human nature to take profits quickly and postpone taking losses. Emotional trading destroys those who lose. Good money management and timing techniques will keep you out of the hole. Losing traders look for a "sure thing", hang on to hope, and irrationally avoid accepting small losses.
Think about the reward-to-risk ratio.
Risk is part and parcel of trading. The reward to risk ratio is an important risk management and trading tool that is used to determine if a trading system is likely to be profitable consistently. It is a measure of risk versus reward, calculated by dividing total potential profit of a trade by the loss you will incur if the trade goes against you. Your reward to risk is calculated using your first exit price.
It is important to understand your level of risk with every trade that you do. The challenge is to manage risk within your portfolio to achieve maximum benefit from your trades. Experienced traders know that the reward-to-risk ratio is critical when it comes to trading. However, this is often overlooked by new and inexperienced traders.
Another important consideration in determining the reward-to-risk ratio that is acceptable to you is the percentage of winning trades you have in your trading system. The higher that percentage is, the lower the reward-to-risk ratio needs to be. For example, if 50% of your trades are winning trades, then any reward-to-risk ratio greater than 1:1 would make you profitable. Any trading strategies with a winning rate greater than 50% would be profitable with a reward to risk ratio of 1:1 or better. I like to see a reward-to-risk ratio of at least 3:1, with a probability of being successful of at least 75%.
Trading using supply and demand zones will allow you to find reward-to-risk ratio trades higher than 10:1 or even 20:1 with very high probabilities of success. When we enter a trade, we will usually have three price targets for exiting the trade. The first target price is the price that is used to calculate the reward. If the profits made after closing the trade at the first target price does not fall in to our defined reward to risk ratio, then we do not take the trade.
Using stop loss orders
When you enter a trade, you have to know where your exit is going to be if the trade turns against you. This defines your risk. Most trading platforms allow you to place your order and your stop order at the same time. This is not as important for swing traders as it is for day traders, but it is still a good idea. As a day trader, your internet could go out right after you entered your order. If you did not have a stop order entered at the same time, and the trade turned against you, then your losses could easily exceed the defined risk by the time you got your internet back or called the trading desk. This is especially true if you are trading any type of leveraged market, like E-Mini index futures or Forex.
I cannot stress this enough: risk management is critical to being a successful trader. If you are not willing to commit to a money management system, you will likely fail. Be smart, be committed, and be professional, and then you will succeed.