Risk Management is the deciding factor that differentiates successful traders from those who struggle. From investing, to swing trading and day trading, risk management is a cornerstone of success. Knowing how to manage risk when you trade eliminates the fear and emotion of trading. However, there are different risk management rules that you may come up with based on your personal trading. Which is also dependent on which asset you chose to trade. From, stock, options, and futures to forex.
When it comes to risk management trading, we want to set up a set of rules to follow so that you gradually build on your success and confidence as a trader. A trader wants to set up their rules in a way that even if they’re having an “off” day or things don’t exactly align with their strategy on that day, they still keep risk and losses at a minimum that undervalue the gains that are made. You may have heard of the “one percent rule”, the risk to reward ratio and daily stops and daily profits. There are plenty of rules out there that traders chose to follow when managing risk. The most important aspect of this, however, is making sure that you actually follow these rules.
Risk Management- Risk Tolerance
Before you dive into the rules and strategies for your risk management. You have to identify the risk appetite at which you are planning to proceed with. The risk appetite is based on what you are willing to risk per trade or per day and based on that you have a daily profit target as well. It varies assets to assets and based on your account.
For example, if you are willing to risk $200 a day, on any given market, that means your trades should be divided into smaller chunks of that overall risk tolerance. For example, maybe risking $50 per trade, giving you 4 trades on the day. With that you have to identify the profit you expect on the day, you want to have a daily profit target that exceeds the max risk on the day. In this scenario, it would be at least $300 a day, which is your initial threshold and from there you judge if you want to continue or not.
If we use a simple example to demonstrate the compounding of losses if you exceed your daily stop loss on the day and settle for a take profit the first time you see green then you will notice that your account becomes death by multiple paper cuts.
The first chart is labeled as Account 1. Where the trader trades 14 days total in the month and had a green month in terms of green days vs red days. 8 Green days and 6 red days. However, poor risk management on average the losing days was $270 in the red. While we said the max risk to be taken was $200 a day. The average of the green winning days was $144 daily. He’s losing more than he’s winning which causes the account to decline by the end of the month.
The next example is Account 2, where the trader abides by his or her risk management rules and accepts the daily stop-loss without exceeding it. It also aims for their daily profit target each time they are green. Notice the gains are not insane because we used the same parameters, 6 red days and 8 green days. Each green day is $300 gain and each red day is a $200 loss. Even though the red and green days are split very evenly you can see that there is a gradual incline in the trader’s account balance.
In summation, it is vital that you abide by your personal risk management tolerance. Make sure your wins outweigh your losses so you can build a curve to the upside in your account, confidence and consistency.
Risk Management- One Percent Rule
The one percent rule is frequently referred to by traders, meaning a 1 percent risk on their account balance on a daily basis OR on a per-trade basis. Depending on the asset of choice naturally. Going as far as 3-5% on a daily basis if the trader trades a high leverage asset with a smaller account like Futures or Forex.
The 1% rule ensures that even when traders are having bad days and are feeling off, the risk is capped to a certain max loss. So, in the long run, the account is not sacrificed to sporadic trading and emotional trading. For example, if you suffer a 50% account drawdown you will have to make 100% of the current account to get back to where you start from. This may take days, weeks or even months to get to that level and even longer to climb out of that hole. However if you abide by the 1% rule even if you have a terrible month you may only be down 10% of the account, meaning you need just 11.1% to get back!
Look at the chart below to better illustrate the point. You can see the more you draw down the account the more you will have to gain to get back to breakeven. If you draw down even 20% of your account you will have to make a 25% gain to get back to breakeven. Which over an extended period of time is not insanely hard if you took a 20% hit over a long time. When it comes to day trading the losses come quick but so do the gains. If you manage to hit your account over 50% then it becomes extremely difficult. A lot of traders fall into the pitfall of the 90/90/90 rules. It’s unfortunate but 90% of new day traders lose 90% of their accounts in 90 days. So just in 3-months, you’re trying to fight back for a 900% win just to get to breakeven.
Understanding this will get you to lean towards the 1% rule so that you can manage your risk. Effectively evading this pitfall that traders experience. When traders take a loss, it’s hard to adjust the emotions and not spiral out of control and make bad decisions after bad decisions. It becomes inevitable. This ruins the risk to reward ratio going for home run trades, getting stopped time and time again. It’s based on probability and if you can manage that you will become successful. Base the probability of trades and risk management so it’s in your favor.
The 1% rule means that you are taking on 1% of your account on any given position. Meaning if you have a $10,000 account you will be risking $100 on any position you take. You can ensure that your risk is capped by having a stop loss that gets triggered at your 1% drawdown max risk on a trade. Meaning that you have to adjust your expected profit! So if you risk 1% per trade, you would want to be making at least 1.5% to 2% per trade. Again if you have a $10,000 account, risking $100, your profit on a position should be $150-$200.
For example, if you are trading the S&P 500 futures. And you are risking $100 for the 1% rule. That means 2 points of risk on the futures market. So if the price is currently at 2900 and you want to short, you get stopped out at 2902. So you want the price to drop to 2898 at least to get $150 of profit. This is all assuming you have one contract on the S&P 500.
Another example, if you are trading stocks. And you have an account that is $10,000. 1% risk is $100. If you want to buy a stock that is currently priced at $14.85 and your stop loss is at $14.55 and your take profit at $20.00. That means you need to identify how many shares you can purchase.
The difference between the entry and the stop is ($14.85-$14.55) = $0.30
The shares you can purchase based on risk is $100/$0.30/share = 333 shares.
But it isn’t 333 shares * $14.85= $4,945 which is nearly half your account. Well, when trading stocks you have a margin to be able to purchase more shares while putting less money down. Your risk is capped!
Keep in mind, sometimes there is slippage in the markets, where you find yourself filled at a different price. So you may want to layer into traders with smaller size so you ensure you get the price you want.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.