No one enters the trading world expecting to lose money. But unfortunately, it’s a reality for many traders. To minimize your losses and protect your profits, it’s important to have a risk management strategy in place. Without one, it’s easy to make costly mistakes that can impact your bottom line. A sound risk management strategy is essential and involves setting stop losses and choosing the right position size for each trade. In this post, we’ll discuss the importance of risk management and outline some tips for developing a strategy that works for you. So, whether you’re just starting out or looking to refine your existing approach, you can reduce potential losses by following these simple steps and hopefully maximise potential gains.
Set Rules to Keep Emotions Out of Trading Decisions
The primary reason to have a trading strategy that incorporates a risk management element is to stop you, the trader making poor decisions that are based on emotions rather than facts and proven strategy. The best plan or strategy is doomed to failure unless it is adhered to, and emotions can get in the way. Hence the reason to have a strict trading strategy that defines when, how and where you enter, manage and exit trades. This obedience to a plan is core to any successful trading approach to eliminate unnecessary and disruptive emotional and psychological influences and is why a risk management strategy is so important.
Use Stops-losses to Limit Losses
One of the most important rules to have in place and to adhere to is the placement of stop-losses! A stop-loss is an order with your broker to buy or sell a market when it reaches or exceeds a price that you set. So, for example, if you bought an asset for $200 and wanted to limit your loss on this trade to $10, you would place your stop-loss at $190. If the price of the asset unfortunately fell, if the price went below $190, your trade would be automatically exited, meaning you lock in a loss of $10.
Placing an exit stop-loss when you enter a trade keeps you true and honest to a strategy. It is also an essential part of being able to calculate your Risk/ Reward Ratio, which we will look at below, which is an integral part of any risk management strategy.
However, it is not enough to just use the stop-loss as a reference point for this calculation. The stop-loss must be kept to, there is no point in placing a stop-loss, then when the market moves towards this stop-loss, then move it away, thereby increasing your potential overall loss.
Use Trailing Stops to Protect Your Profits
Alongside using stop-losses to limit your losses, you can also use trailing stops to protect your profits. A trailing stop is a type of stop order that trails behind the current market price as it moves in your favour. The trailing stop automatically adjusts to the changes in market price and follows along at a set distance, or trailing amount below the current market price if you are long, or above the current market price if you are short.
For example, if you buy an asset at $100.00 and place a trailing stop for an asset initially at $95.00, but set it at $5.00 trailing, then your stop loss order will automatically adjust up to $96.00 if the stock price increases by $1.00 to $101.00. If the stock price decreases, then your stop-loss order will stay at $95.00 for a stop-loss of $5.00.
The trailing stop is a great tool to use to lock in profits as the market price moves in your favour while still protecting against downside risk. It is important to remember that the trailing stop is not a guarantee that your position will be sold at the trailing amount, but rather it is a limit order that will only execute at or better than the trailing amount.
Trade The Right Position Size to Optimize Risk
One of the biggest mistakes many traders make, even those with experience, is to trade too large a position size to become overexposed to the market. So, how do you decide on your position size? There are several factors that can determine this, but there are some basic calculations you can make to get a guide to how much you should be trading in any particular trading position.
Here we will look at:
- The 1% Rule
- The Risk/ Reward Ratio
- The Hit Rate
The 1% Rule
As a rule of thumb, it is widely accepted that a 1% rule for potential losses on any one trade should be no more than 1% of your total trading account size, the amount that you are willing to lose in total. Many traders add extra rules to this rule, that maybe you do not allow yourself to lose more than 2% on anyone trading day, maybe no more than 5% in a trading week.
So, for example, if you had a $10,000 account, then you should not look to lose more than $100 on any trade.
The Risk/ Reward Ratio
The Risk/ Reward Ratio is a calculation that measures the ratio of the possible loss from a trade, the Risk, compared to the anticipated potential profit, the Reward.
Risk/ Reward Ratio = potential loss / potential profit
So, if you bought an asset at $200 with a target to take profit at $220, and placed your stop-loss at $190, then your Risk/ Reward Ratio would be as follows.
Risk/ Reward Ratio = potential loss / potential profit
= (200-109)/ (220-200)
As a rule of thumb, you would certainly look to enter trades with a Risk/ Reward Ratio of greater than 1:1, so at least looking to make as much as you risk. Ideally, you would set up any trade with a Risk/ Reward Ratio better than 1:2.
To then determine your position size and how much you could lose on any particular trade, you should, first of all, make the above “1% Rule” calculation, and from our example, you would see that you could afford to lose $100 on a trade.
Then, using the next example we used to calculate the Risk/ Reward Ratio, we could see that our potential loss on this trade was $10 for each 1 unit of the underlying asset we had bought.
So, in this example, we could afford to buy 5 units of the asset, which would mean that we would only lose $100 of the trade that went against us. If the trade was profitable and hit our target, we would realise a $200 profit at our calculated Risk/ Reward Ratio of 1:2.
The Hit Rate
The next calculation we are going to look at is the Hit Rate. The Hit Rate is simply the number of profitable (or winning) trades for a trading strategy over a tested and defined period of time, divided by the total number of trades over this period, usually expressed as a percentage.
For example, if you have designed a strategy that over a one-week period produces ten trades, seven of these trades are profitable trades, and three trades result in losses, then the Hit Rate is 7÷10, which, expressed as a percentage, is 70%.
There is generally always a trade-off between the Risk/ Reward Ratio and the Hit Rate, with most strategies either producing a strong Hit Rate, that is, the number of winners compared to number of trades and a lower Risk/ Reward Ratio, or a lower Hit Rate and better Risk/ Reward Ratio. We look at these various measures and, in more detail at the relationship between the Risk/ Reward Ratio and the Hit Rate in our post Risk/Reward Ratios And Hit Rate.
Another vital factor when looking at a risk management strategy is to diversify trading risk. Portfolio diversification is an important strategy for reducing risk without sacrificing expected returns. This concept of Modern Portfolio Theory was first formulated by American economist Harry Markowitz in his paper “Portfolio Selection” and has been widely used since its publication in 1952.
Portfolio diversification is a strategy that aims to minimize the risk of investing or trading by spreading your capital across a range of different asset classes. The logic behind diversification is that, by investing or trading in a variety of assets, you can reduce the impact that any single investment or trade has on your overall portfolio. Portfolio diversification is not a guaranteed way to make money, but it can help to reduce the overall risk of your investment portfolio or your trading strategy.
With a particular focus on trading, portfolio diversification would require not having a number of trades that are positively correlated at the same time. For example, it can be assumed that the US stock market and the UK stock market have a strong positive correlation, they tend to go up and down with each other. So, if you were long both the S&P 500 index (US) and the FTSE 100 index (UK), you would, in fact, have greater exposure to the overall market than just two separate, uncorrelated trades. If following our “1% Rule” as above, you had a 1% long exposure in the S&P 500 and a 1% long exposure in the FTSE 100, you would, in reality, have a 2% exposure. And this is not just the case for two equity indices as in this example. Different asset classes can be positively correlated, for example, the USD/JPY currency pair and the NASDAQ 100.
Trading Risk Management Strategy Takeaways
A risk management strategy is an important tool for traders. It helps to identify and manage risk, set limits on position sizes, and set up solid trading opportunities. A good risk management strategy can help to protect capital, prevent losses, and maximise profits. While there is no foolproof way to prevent losses, a well-designed risk management strategy can give traders a significant edge. As we have looked at, some common risk management techniques include:
- The setting of rules to avoid the influence of emotions
- Position sizing to protect capital and to not overtrade
- The use of stop-loss orders and trailing stops
- The calculation of the 1% Rule, Risk/Reward Ratios and the Hit Rate
- Diversifying risks by avoiding over-exposed trading in highly correlated assets
By incorporating these techniques into a risk management strategy, you should be able to improve your overall trading profitability and long-term success.