Being a trader is synonymous to being a risk manager. This is because every good trader is someone who can manage risk well enough to profit.
A profitable trading strategy is the first step to make it as a profitable trader. Moreover, successful trading requires effective risk management to protect your capital and achieve long-term success. Only with proper risk management can a trading methodology have positive expectancy [link] to give profitable long term results.
For a complete guide on trading check out this article. In this article here, we will explore key aspects of trading risk management:
- percentage risk
- risk per trade
- Stop loss and placements
- R-multiple
- risk-reward ratio
- drawdown and sizing down
Understanding and implementing these principles will be crucial to longevity in the financial markets. After this article you should have a great grasp of how to manage risk.
Let’s get right to it.
Percentage Risk
The first thing that is important about trading is understanding percent risk. Every trade idea should have a maximum amount of allocation of risk of the account in percentage. Some traders will risk 4% on a trade idea meaning that if they lose 4% of their account they give up on the idea.
This is especially valuable as traders are on occasion wrong. For example : If a trader has an idea that the index futures market for S&P 500 will bottom and wants to buy a few contracts to profit on a potential upside move, they will have to put risk on that trade idea. Either the market will bottom and reverse like the trader anticipated, or it will continue to move lower. Say they risk 1% per trade they can be wrong 4 times before they have to admit that the trade idea is wrong. This is a great way to avoid being wrong on the overall trade context [link] and not blow up the account.
Risk per Trade
In the previous example we went over a maximum percent loss per trade idea, it is also important to limit the risk per trade. Typically a rule of thumb is to risk 1-2% of your account size per trade.
The reason for this is that all trading systems will go through periods of drawdowns. It is better to lose only 5% of your account at 1% risk per trade if you lose 5 consecutive trades in a row. Whereas if you risked 10% per trade you would lose 50% of the account. The maximum risk per trade mitigates your losses during a typical drawdown period.
You can risk more than 1% per trade if you want to be aggressive but this will give you an equity curve that is less smooth [link]. Not all trade setups are equal and in some strategies you can risk more on certain trades [link]. By limiting your risk exposure, you can withstand losing trades and avoid significant drawdowns that may impair your ability to recover psychologically and continue trading.
Stop losses and placements
In the above example of a real trade I took, the stoploss was used to keep the loss at 100$. The idea was to go long and look for a favorable risk reward but when the market hit the stoploss the trade idea was cancelled and closed at a loss. Subsequently the market reversed and kept going lower and had the stop not been used the loss would have been much bigger.
Stop Losses are crucial to limit risks on trades. It’s important to use them alongside a proper position sizing to ensure that the risk per trade is not exceeded. Additionally it is important to place stop losses at optimal locations to ensure that winning trade ideas do not get you stopped out before they work in your favor [link].
R-Multiple
Measuring Trade Performance The R-multiple is a metric that quantifies the relationship between risk and reward in a trade. In the last paragraph we talked about maximum risk per trade. If the average risk per trade is 2% then your R is equivalent to 2%. If you take a trade and gain 4% you can say instead that you gained 2R. It is better psychologically to think of profits and loss in relation to R as it allows you to separate yourself from the money in the account to maintain good trading psychology [link]. This becomes more apparent when trading with larger risk.
Risk-Reward Ratio
One of the key components in risk management is a good risk reward ratio. Every trade has a downside risk, so naturally we should seek to find an opportunity where the reward outweighs the risk. The risk-reward ratio measures the potential profit divided by the potential loss of a trade. If you are risking 1% on a given trade and the reward of the trade is +3%, the Risk-Reward ratio or RR is 3:1. A good risk-reward ratio ensures that potential profits outweigh potential losses to maintain a positive expectancy trading system. My preferred RR is 3:1 and 2:1 but there are various possibilities that work profitably [link].
Above is a favorable risk reward trade idea. The Risk reward ratio of the trade is 3:1.
Drawdown and sizing down
Drawdown refers to the max account value decline. It can be measured in % or R units. A drawdown period happens when a trader goes through multiple losses in a row. This is an inherent part of trading, and managing it effectively is crucial to protect your capital.
Sizing down can act as a protective mechanism to navigate unfavorable market conditions and avoid significant drawdowns. Reducing position size based on performance after a series of losing trades or during unfavorable market conditions is a great way to protect your account. By decreasing your risk exposure during challenging times, you preserve capital until your system starts performing favorably. The best time to know when to size down is by knowing what drawdown is typical in your system based on backtesting [link].
Conclusion:
Mastering risk management is a fundamental aspect of successful trading. By implementing risk-reward ratios, managing risk per trade, tracking R-multiples, setting percentage risk limits, navigating drawdowns and sizing down strategies, you can effectively manage risk and protect your trading capital.
Remember, trading involves uncertainty, and losses are inevitable. However, by prioritizing risk management and adhering to disciplined trading practices, you can increase your chances of achieving consistent profitability and long-term success.
Let me know if there are any other questions you have about managing risk. Leave a comment and join our email list for more articles like this.
Happy trading, and as always manage your risk!
Andrew Akl
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