Risk management is the most important topic you will ever learn about when it comes to trading. Improper risk management is the number one reason why most new traders fail.
This guide outlines what risk management is as well as some useful risk management techniques for Stock, Futures, Forex and Option traders.
What Is Risk Management
Risk management is the process of analyzing and mitigating losses in your trading. In more basic terms, it’s the number one thing that will determine your success or failure as a trader.
Trading is probably the world’s only profession where the rank amateur has a 50/50 chance in the beginning. You can have short-term success by pure luck and that fools people. Being successful long term requires a number of attributes and one of them is having a solid risk management plan.
If you trade without a risk management plan you’re simply gambling, and in the long run most gamblers lose.
Reward to Risk Ratio
To be profitable as a trader how often do you need to be right?
I’ve asked this question hundreds of times in the past at training workshops and seminars. The general consensus is somewhere between 60% – 75%. The lowest answer I generally get is around 55%.
All of these are wrong. You could be right 30% of the time and still be a very successful trader. It all comes down to your Reward to Risk Ratio.
The ratio analyzes the amount of risk you take on given versus the return from the expected profit. This ratio is calculated by dividing the amount of profit you expect to make to make on a trade (the reward) by the amount you stand to lose on a trade if the price goes against your position (the risk).
For example, let’s assume we go long Facebook at $118.20 with a stop loss set at $118.00 and a profit target of $118.70 as seen in the chart below.
On this trade we would be risking 20 cents to potentially make 50 cents.
Reward to Risk Ratio = Reward / Risk
On this trade our Reward to Risk would be 2.5 to 1. ( .5/.2 = 2.5 )
Now that you understand how to calculate your Reward to Risk Ratio let’s take a look at how often you need to be profitable as a trader to be successful….
As seen in the chart above, you could have a win percentage as low as 30% yet still be profitable if you were using a 3 to 1 reward to risk ratio.
I wouldn’t suggest trading a system that has a win percentage of less than fifty percent especially if you’re a new trader. Most people can’t handle the drawdowns and psychological effects of trading a system where you only win 3 out of ten trades. Typically it will lead to erratic behavior and poor decision making.
I have traded with some of the best traders in the world throughout my career and typically they target a win percentage of 60 percent to 70 percent on the high end with a minimum Reward to Risk of 2 to 1.
Calculating your Reward to Risk ratio should always be your final step before taking a trade. No matter what strategy you trade not all setups are created equal. Some will expose you to more risk than necessary and should be trades that you avoid.
You don’t have to calculate the ratio down to the exact decimal point prior to entering a trade. You simply need to calculate a fast rough estimate ensuring that you’re above what you set your minimum reward to risk to be.
NEVER enter into a trade without having defined exactly where your stop loss is going to be…plain and simple.
You have to know exactly where you’re getting out before you get in. You make that decision prior to entering a trade while you still have objectivity. Once you enter a position you will lose some of your objectivity.
Not defining your stop loss prior to entry will result in erratic decision making and ultimately larger than necessary losses.
I personally prefer using physical stop loss order than a mental order (saying you will manually close out at a given price). Manual stop losses can be missed and lead to blow ups. Never change your stop loss unless you’re moving it in your favor.
Developing a game plan for your position size is something that most trader never do. Typically traders will determine their position size at the time of taking a trade depending how they feel about a trade…not a good idea.
Position sizing should be determined what your standard amount you risk per trade is and second your recent trading performance. If you state in your trading plan that you will risk 1% per trade you should do just that…on every trade. The only time your position size should change is if you’re cutting back on your size due to a recent losing streak or due to market factors like low liquidity or volatility.
So how much should you risk per trade? Ultimately it comes down to how large of a drawdown you can psychologically handle while maintaining a cool head.
Most people think they can handle a drawdown of 30% or even greater. Having taught thousands of traders I can tell you this simply isn’t the case. Typically traders begin to make erratic decisions and stop following their trading plans after hitting a 10 to 15 percent drawdown.
If you’re new to trading I suggest you never risk more than 1% on a given trade. If you are consistently profitable and have been trading for some time you can increase this some but I would never go over 2% of your account balance.
You can see on he chart above that as you lose more money it becomes even harder to get your account back to break even. If you think you will be able to handle a %50 percent drawdown think again. Not only would it require extreme discipline and a strong mind, but you now have to make a 100% gain to get back to break even!
By now, I hope you have it drilled in your head that you must avoid the temptation to trade larger than your account balance justifies. Doing so will put you ahead of most traders and the ability to survive your losing streaks.
Becoming a successful trader requires you to accept that losing is part of the business. The best traders in the world still have extended drawdowns. Sometimes they can last for weeks or months prior to getting back to break even.
When you have a drawdown, which you will, what are you going to do?
If you don’t have an precise answer to this question then you need to formulate one prior to taking another trade.
I have learned over the years that statistically I would have been better off if I stopped trading for the day after three consecutive losses. For newer traders I suggest you stop trading for the day after two consecutive losses.
You also need to know your “uncle point” when it comes to consecutive losing days. If I have two consecutive losing days in a row I cut my position size in half. If I’m negative on the third day I take the rest of the week off.
There will always be more trades to take. The question is will you still be trading and have the opportunity to take them?
Risk Management Tips
- Calculate you risk to reward ratio prior to ever entering a trade.
- Never risk more than 2% on a trade.
- Stop trading for the day after two consecutive losing trades.
- Stop trading for the week after back to back max down days.
- Two losing days trading in a row cut your position size in half.
- Never place money into your trading account that you can’t afford to lose.
- Use the Risk to Reward ratio to invalidate certain trade setups.
- ALWAYS use a stop loss and define the exact price prior to taking a trade.
“Here’s how I think of my money – as soldiers – I send them out to war everyday. I want them to take prisoners and come home, so there’s more of them.” Kevin, O’Leary. This quote from Kevin pretty much sums up how you should think about risk management.
Precisely define your reward to risk setups, position size, and max drawdown and then FOLLOW it! Do this and you are 90% of the way there.