Successful trading is not possible without good risk management. Risk management is probably one of the most important things when it comes to trading. But sadly most traders fail to do this correctly. This is the main factor that distinguishes the 90% of losing traders from the winning ones. No matter how good a strategy is, with wrong or no risk management it is doomed to fail. Basic risk management is very simple but can improve a traders performance a lot.
What Is Risk Management:
In essence, risk management is a ‘way of managing risk’. This management tries to minimize the risk as much as possible until it can be tolerated. Obviously, you can’t really eliminate risk to 100%, as participating in the markets does theoretically always carry risk with it (unless prices are stated incorrectly and give arbitrage opportunities, but this is a topic for a different article). Nevertheless, risk should be minimized as much as possible and there are different ways of doing this. Methods of risk management of course depend on different factors like your trading style and the asset classes you trade in. Risk management is not a thing you do once to get it over with, it is a constant ongoing process for your positions and portfolio.
How To Manage Investment Risk – Trading Risk Management Techniques + Example
Finding/Identifying/Assessing Your Risk
Risk management starts before opening any positions and it doesn’t stop there. Risk management actually should be a big factor influencing your set up process and trade decision-making. When finding and setting up potential trades, first of all look at the risk that the position would carry with it. Finding out what this is, already heavily depends on what you are trading and how you are trading it. For example, if you are trading stocks, currencies or similar securities, you should use stop losses to limit your risk. The price point where this stop loss is set at, will then be your max loss and in other words your risk. Let’s show how this works with a simple example: stock XYZ is trading at 100$, you want to buy it and hope that the price rises. If the price falls to and below 90$ you want to get rid of it and sell it. Therefore, you set a stop loss at the 90$ price point. This would mean that you have 10$ of risk (per share). This shouldn’t be anything new for most traders.
The price point to set the stop loss, shouldn’t be set random either. It should be set at that point, where the trade setup does not make any sense anymore. For example, stock ABC has been trading between 90$ and 100$ for quite a while now. You want to profit from this and want to open a long position in ABC when it comes back down to around 90$. A rational stop loss in such a scenario would be a little under the 90$ mark, somewhere around 88$. This would be a good point, because the setup (price moves between 90-100$) doesn’t make any sense anymore (because the price has moved out of this range).
If you trade other investment products like derivatives (options, futures…), you often don’t set stop losses because other products sometimes are limited risk strategies or stop losses just wouldn’t make sense on these. Then your risk could be your max loss (if there is one: defined risk) or your buying power reduction if it is an undefined risk position.
After assessing your risk, you should look at other factors like your risk to reward ratio and probability of success. These two go hand in hand. Finding these, once again depends on what you are trading and how you are trading it. Derivatives like options often have precise probability of profit (POP) calculators based on historical data. So finding the probability of profit for these positions can be as easy as reading a number of your screen. The same may be the case for your risk to reward ratio. You already found the max loss, so the only thing missing to finding out the risk/reward is the reward or the max profit. This can be found very easily on limited profit strategies. But if you have an unlimited profit position like a stock or a long option, you can’t just find a reading for this. Therefore, similar to the stop loss price point, you should find a price point that would be a logical point to cash the profit. This should be the point, where the setup once again stops being profitable. A spot where you have more to lose than to win or more signals indicate a reversal than indications for a continuation of your movement.
To simplify this I’ll use the example from before, where we had stock ABC trading between 90$ and 100$. The planned entry point was around the 90$ mark and a good price point for a stop loss would be a little under 90$ because this would break the setup as the price wouldn’t be trading between 90$ and 100$ anymore. A logical point to take the profit would be a little under the 100$ mark as the price likely will fall again after hitting price in that range: so let’s say a limit order at 97-98$ to take the profit.
Now we already have the following data for this setup:
- Current Trading Price Of ABC: 91$
- Planned Stop Loss: 88$
- Planned Limit Order: 97$
- Risk (Per Share): 3$
- Reward (Per Share): 6$
- Risk/Reward Ration: 1/2
The only thing missing now would be a probability of success. Obviously we can’t determine an exact number for this, but we can definitely come up with an estimate. Things that would improve the probability of profit would be: many signals pointing in same direction and evidence that the setup worked before. The evidence could be that a certain price point (90$) got tested many times before and the price never broke through this point.
We’ll just say that our 90$ mark got tested multiple times and the price never went through it and that additional signals from indicators or somewhere else all show that the price will likely rise. This shows us that the probability of profit likely is higher than the one of other trades. Nevertheless, stock trades, currency trades or other similar trades often don’t have a much higher probability of profit than 50%. Therefore, it is important that the risk reward is better than 1 to 1.
Earlier I mentioned that risk/reward and probability of profit go hand in hand. The reason for that is because they depend on each other. If you just look at one of these two aspects, you can get a totally wrong impression of a trade. For example, if you hear that a trade has a 70% chance of being profitable, you’ll probably think that it is a great trade. But if you get to know that the risk/reward on the same trade is 5/1, you’ll see that the trade isn’t that good after all. This setup would mean that you have a 70% chance of winning 1$ and a 30% of losing 5$. If you would repeat this trade over and over, you’ll eventually go broke.
This does not mean that you always need an amazing risk/reward or an amazing probability of profit. But together, they should be good and make sense. Before every entry I do this calculation:
POP x Max Profit – (100-POP) x Max Loss
If the result of this calculation is greater than zero, I consider the pricing of a trade as good. The calculation looks at the winning potential of a trade over the long term. If the result is greater than zero, it means that this trade would theoretically generate a profit over the long term.
Step 2: Limiting/Adjusting Risk To Your Account – Position Sizing In Trading
After you assessed your risk on your potential position and it was good enough, your next step would be to adjust the risk to your personal account. In other words, this is the step where you select your position size. Correct position sizing is one of the most important steps in risk management. This differentiates winning from losing traders. Sadly, extremely many traders get this wrong. A common beginner mistake is to trade in way too big position sizes. A bigger position size can lead to a bigger profit from smaller moves, BUT the same goes for the downside. Big position sizing in trading will lead to big profits AND big losses. I don’t care how good of a trader you are, it is practically impossible to win all the time over the long term. There will be losing trades. Therefore, you don’t want to allocate too much capital per trade. Let us say that you allocate 100% of your capital on every trade. This would mean that all it takes is one bad, losing trade to wipe you out and believe me: this trade will come! Even if you traded with an allocation of ‘only’ 50%, you will lose half of your account on one bad trade. This is completely unsustainable.
Therefore, it is very important to keep all positions small. If you do this, you won’t only be able to sleep better at night, but you will be able to afford to lose as well. If you lose with an allocation of a few percent, it doesn’t really impact your trading because you only lose a fraction of your account. You’ll literally be able to lose once, twice or even more times directly in a row. This will sadly happen to the big majority of traders and it is so damn important that your account will be able to survive this.
Good position sizing is around 1-5% allocation per trade. Don’t be stupid and allocate much more than this for one trade. If a setup is very good and less risky, you can scale up to around 5%, but don’t go far beyond this. The only exception I can think of is if your account is very small and you can’t afford to open certain positions. Usually, I really advise to find a job or whatever to be able to deposit more, but otherwise you could try to go up to 10%. But beware that this is by no means ideal and should be avoided as much as possible.
Additionally, it is a good idea to keep some capital of your account in cash and don’t allocate everything. I usually never allocate more than 70% of my account capital (mostly much less). This has several benefits. These being the ability to open positions when you find very good opportunities, avoiding things like margin calls and much more…
Portfolio Risk Management
Furthermore, there are more aspects to risk management like portfolio risk management. This in essence is keeping your portfolio diversified, uncorrelated and neutral. To learn more about this, I recommend this ARTICLE! I discuss the importance of the portfolio and diversification under 4.
Depending on your trading style, you should continue managing your risk the entire time while a position is open. Optimally, you should re-assess you risk, probability of profit, risk/reward and more over and over again. After doing this you could potentially move your stop loss up if it makes sense. But this really depends on your trading style and time frame. This is mainly necessary for short term trades that are open for a few hours to a few days at max.
Some trading styles also allow you to set up and put on trades that don’t have to be readjusted and supervised all the time. In these trading styles you can often leave positions open for days or even weeks without having to check on them.
One of these trading styles is the way I trade which is high probability options selling. You can learn more about it under my education center where I offer three free courses. You can access the free education HERE!
Risk management is very important when trading. A trader can’t be consistently profitable over the long term without any form of risk management. Risk management basically is:
- Being aware of your risk, (assessing/identifying it)
- Limiting and adjusting it
More specific important aspects are the probability of profit, risk/reward and position sizing. If someone tells you to trade in huge position sizes and to neglect risk, chances are high that he is a scammer, profiting from your losses. Generally, in most trading styles you should keep your losses as small as possible.
“Cut Your Losses Short And Let Your Winners Run”
This article is nothing else than a brief introduction to risk management for a retail trader.
Never invest more than you can afford to lose.
This article about risk management mainly is relevant for active traders and not very long term investors that buy stocks or other securities and hold these for years.