Your money is the item at risk in the financial markets. When you enter a trade you are “risking” your money because it can be lost (very quickly).
Think of trading as a game of what you can keep rather than what you can earn. The goal is to suffer as little loss as possible, i.e. reduce your risk.
You can’t control the market, but you can control how exposed you are to it. The hard truth of trading is that unless you are a whale, your actions won’t have any major effect on price and you can lose money a lot easier than it can be made.
Risk management is simply money management, the amount of exposure (risk) you have to a given market is basically defined as what percentage of your capital is actually in a position. You can think exposure level in percent, for example, if you have a $1000 account and you put down $250 to enter a trade, you are now 25% exposed.
Higher percentiles of exposure means you are at a greater risk of draining your account. It’s easy to think “yeah, but more exposure means more profits” and while this is true, you must realize that mindset is one of an optimist – you are being blinded by the best possible outcome.
To be a consistent (successful) trader its necessary to adapt the mindset of a pessimist, meaning you expect the worst possible outcome. The trick is that your profits must far outweigh your losses and this is achieved through these basic risk management principles:
1. Plan your trade
The first step to taking any trade is to make sure you are taking a position that goes with the prevailing trend. This is achieved by drawing basic trend lines to find the direction of the trend and areas of value (support and resistance) where you can potentially enter a trade.
Oscillators are extremely useful in markets that are trading in a range, they also useful in identifying whether an existing trend is gaining or loosing strength. In any case, the goal is to buy support and sell resistance, trend lines and horizontal lines will are critical to help determine your targets.
The risk to reward ratio of the given trade is determined by the difference between how much you’re willing to lose (stop loss) and your expected profit (target). If you are willing to risk 1% to make 4% that is a risk to reward ratio of 4:1.
Example: $100 position with a 5% stop loss ($5) and profit potential of 20% ($20) gives you a risk to reward ratio of 4:1.
2. Choose your position size carefully
Now that you have identified your buy and sell targets, it’s time to decide how much of your capital to risk for the given trade. It’s never a good idea to “go all in” on a given instrument as any wrong turn in the market can be devastating to your account.
The volatility of a particular instrument should play a role in choosing your position size. Something more volatile would call for a smaller position size because of the likelihood of the market going against you and the resulting loss could be magnified.
|Loss Incurred||Gain Required to Break Even|
The total amount risked in any given market depends on how aggressive of a trader you are but a general rule should be limited to 5% of total equity, this is how much you are willing to lose if a given trade doesn’t work.
As a general rule of thumb, limit your trading activity to 50% of your total invested balance. This means that at any one time, no more than half your capital should be committed to the market.
If your account is $5,000 for example, limit your trading balance to $2,500. The rest is kept in reserve for periods of draw down. With a trade balance of $2,500, you wouldn’t want to risk more than $125 on each market position.
Tip: Avoid moves based on emotion, if you feel a rush of adrenaline, take a hard second look. Planning your trades will reduce the amount of transactions you make an in turn save you money on commissions.
3. Dollar cost average your orders
Once you have an entry point and position size set, it’s time to enter the position. Dollar cost averaging is a technique you should use to get the best entry price by breaking your limit orders into chunks and spreading them around your target area.
What you are effectively doing by averaging is taking a bunch of small positions instead of taking a single position at one time. This technique is especially important where volatility is high.
It’s a good idea to “dip your toe” in the water so to speak when entering a highly volatile market, add to your position as the market gains strength in your direction. I also recommend using this technique when taking your profits by placing your exit orders above and below key areas of value.
4. Set an appropriate stop loss
Stop orders take the emotion out of trading because they execute when told without hesitation. Simply put, not having a stop-loss means you aren’t planning your trade.
One of the most devastating mistakes a new trader can make is not setting a stop-loss order. There is no shame in getting stopped out, think of a stop-loss order as an insurance policy on your trade.
Without a stop-loss, you risk losing everything because the truth is no matter how good of an analyst you might be, anything can happen and you can’t predict the unpredictable.
You can use the dollar cost averaging technique for stop loss orders as well. This protects you from stop hunts, preventing your entire position from getting wiped out from a stop hunt.
5. Position Management
Manage your trades wisely and don’t micro manage your position. How each trader handles this principle will depend on their individual trading style but the general rules still apply for everyone.
Utilize dollar cost averaging, enter a position with a small amount and then add more as the trend starts to move in your direction. Take some profits off the table in small amounts as the trend progresses, nobody has ever gone broke from taking profit.
Avoid micromanaging your position by obsessing over price action every minute. You should have a timeframe for your trade in mind, check on it in reasonable intervals based on the timeframe.
Whichever timeframe you used to plan your trade should be the timeframe you use to manage the trade. This means if you decided to enter a trade based on a trend seen on the 4 hour chart, use only the 4 hour chart to manage the trade. Go one timeframe lower to trigger entries and exits and one timeframe higher to get a “bird’s eye view” of the trend.
Sticking to these principles keep you consistent over time, trading is a game of chess where you fight little battles to win an overall war. Expect the market to go against you and expect to lose trades but know that your winners will far outweigh your losers.
If you consistently take high probability trades that offer a risk to reward ratio of at least 2:1 you will end up profitable over time. We have only covered the basics in this lesson, the topic of risk management can be quite complex but the techniques discussed here are effective in protecting yourself from unnecessary losses.