3 Techniques for Risk Management in Trading
In this article, I will discuss 3 techniques for Risk Management in Trading. Please read my previous article discussing How to Day Trade with 5 simple GAP Trading Strategies. Here, I will discuss my trading secret to success.
- Risk Protection
- Risk Profile
- Active Trade Management
Introduction to Risk Management in Trading
Trading knowledge, including technical analysis, good strategies, and chart reading, are all necessary but alone are not enough to make you a successful trader
Today’s post will be one of the most important you’ll ever read. Here, I will discuss risk management. Because if you apply the risk management strategies, I can guarantee you’ll never blow up another trading account, and you might even become a profitable trader
Risk management is the foundation of a successful trading system. We can basically break risk management into 3 categories:
- Risk protection
- Risk profile
- Active Trade management
Let’s discuss all these in detail
To protect against something, it is necessary to begin with an understanding of what it is that you are protecting against. It is fine to say that protection is being taken against potential loss. Losses are an inevitable part of the trading game. We need to accept losses as the cost of doing this business. The world’s best traders lose a lot.
- The underlying root cause of a loss in any trading situation is the trader’s fear and greed.
Let’s start with fear
Fear warns you that something doesn’t feel right about a trade you took; you have to figure out what is going wrong.
Any fear that does exist works in two ways.
- There is the fear of missing an opportunity (FOMO)
- There is also the fear of incurring a major loss
The protection against each is somewhat different.
Let’s discuss each in-depth
Protection against Fear of missing an opportunity (FOMO)
How does it affect our trading?
- The fear of a missed opportunity may result in a premature trade. What most of us do We’re so afraid of missing a profit that we tend to constantly trade too early.
- The common mistake is to conclude that a little bit of a wait is no problem because the eventual result will justify it. How do you know it’s going to be just a short wait? That’s an assumption.
- A much bigger problem, however, is that the judgment (upon) which the trade is based may be invalid. Because that opportunity has not had a chance to fully develop, something could go wrong. If it does, the position will probably be stopped.
HOW TO PREVENT Fear of missing an opportunity (FOMO)
Unfortunately, there is no mechanical tool that will invariably keep you from trading too early.
- Protection against the fear of missing an opportunity is discipline and confidence in your method
4 Steps for Disciplined Trading:
- Take direction from the market, not from your hopes, greed, or fear. Most traders do not see the market clearly. Control your beliefs about the market
- Predefine your risk before taking a trade
- Cut your losses without hesitation
- Use a systematic money management plan
Confidence in your method makes all the difference in trading. You cannot make money unless you have total confidence in your methods. But the problem is that you will not have confidence in your methods if you are not making money. To become a consistently profitable trader, you must develop a method that suits your personality. When developing a trading plan, you should understand the logic behind each step. This will boost your confidence and discipline you to follow the plan. Confidence believes in your ability to do something.
To be successful in trading, we must have a method with an edge. We need to trade the method long enough.
Ignoring the results of individual trades to win. This is not possible without total trust in your methods. Losses shouldn’t worry you if you have confidence in your trading method. Just take it and move on. Successful trading is not totally avoiding losses but winning more than what you lose. For every trade we enter, there could be four outcomes. a) Big Loss, b) Small Loss, c) Small Win, and d) Big Win. Let us remove the Big Loss from this. Small Wins will take care of Small losses, and Big wins will remain with us. Ensure that your trading plan eliminates the possibility of losing big. “You can’t make money if you are not willing to lose. It’s like breathing in, but not willing to breathe out” Ed Seykota
Fear is of incurring a major loss.
The other type of fear is of incurring a major loss. It is done with a stop order. The stop order lets the investor take comfort that if his appraisal is badly flawed, his loss will be cut short before it becomes a disaster.
If a trade has been made too early (FOMO), the stop may be too close to survive the remaining and unknown action of the trading range. In these cases, the position may be lost to a stop, resulting in a loss even though the eventual outcome has been properly diagnosed in the market.
- Using a stop correctly means maintaining a profit-risk ratio in your favor. Be careful, however, that you don’t end up using this idea in a way that unduly restricts the stock’s ability to move.
- Over the years, we have found that the most generally acceptable profit-risk ratio is 3 to 1. First of all, it prevents a major loss it also gives the stock some breathing room. It is unreasonable to assume that every stock will be caught exactly at its turn.
- A long position may move somewhat lower before it turns up, and a short one may move somewhat higher before turning down. You have got to allow some margin for error.
How to place a proper stop-loss order?
Step 1 =Identify the structure of the markets
Step 2 = Place your stop loss beyond the structure
Let me explain…
Identify the structure of the markets.
Step 2 = Place your stop loss beyond the structure
These are important points in the market because that’s where most traders will place their stop loss.
Because if the price trades beyond it, it will invalidate their trading setup as they know they are wrong on their trade. But, the problem with placing your stop loss near these levels is that it gets triggered easily by smart money.
Why do they do this?
Smart Money is paid to collect VOLUME (where Liquidity is found). He only targets places with higher Volumes, and he collects them.
How do they do?
The spikes in one direction or the other hit the stop losses of either sellers or buyers.
Protection against greed
Greed is perhaps more basic. When it is responsible for a loss, it is a loss of already-realized profits.
From an objective standpoint, you would think that when a reasonable profit has been developed in a position, there would be great satisfaction in taking that profit. Unfortunately, it doesn’t always work that way. Let’s analyze the situation.
- After the market is given a certain profit level, there is a tendency to want more (greed) instead of being satisfied.
- The desire to have more profit causes the situation to be analyzed from that standpoint (greed) and not from the standpoint of things as they really are. At that point, greed has taken control, and the profit already gained is jeopardized.
- Consider these examples. A stock is in an uptrend and has been for quite some time, with good upside progress being the result. There are two good reasons here for selling this stock. The stock becomes overbought and reaches its upside objective or key resistance.
Here’s an example of Risk Management in Trading:
You go long on a breakout, and the trade goes in your favor immediately. Shortly, you have open profits of 3R, and your trading strategy tells you to exit your trade (because the market has reached a key Resistance). But, you tell yourself: “This chart looks so bullish, I should hold this trade longer for bigger profits.” So, you hold onto the trade. The market slowly starts to reverse and wipe out some of your open profits. Now you’re anxious, but tell yourself: “Never mind, I’ll exit the trade if the market increases slightly.” Unfortunately, the market didn’t go higher and retrace all the way and hit your stop loss.
How to overcome greed
- Pre-establish a sell or cover order in the area of the anticipated objective.
- Or once the price is reached in the anticipated objective, tighten your stop loss(trailing stop order)
Pre-establish a sell or cover order in the area of the anticipated objective.
- The only way to totally protect oneself from greed is to take steps against it at the time a position is; one of the best ways to do this is to predetermine and preestablish a sell or cover order in the area of the anticipated objective. When the stock reaches that level, the established. The position will be automatically eliminated and the profit protected.” Greed won’t even have a chance.
TRAILING STOP ORDER
We identify zones we’re happy to trade and then work the best entry we can within that area. Stops should be placed in a location that invalidates the trade.
Not every position is going to make it to its indicated objective. I mean, not every position hit the target. In those cases where the ultimate objective is not met, how to protect the position? The stop order can be used very effectively for this type of protection if used correctly throughout the life of the position.
That means repositioning it as the move progresses. The first objective in re-positioning a stop is to get up to or down to the trade price as quickly as possible. Once this is accomplished, the investor’s funds are protected against loss, and he can breathe a little easier. This repositioning, or any to follow, cannot be done carelessly. Initial capital may be protected if it is, but profits will likely be scarce.
The rest periods between the periods of progress are extremely important. They will indicate when a stop can be moved and, more importantly, to what level it can be moved. A resting period will either be a normal correction or a horizontal consolidation. The stop should be re-positioned just above or below the extremes of these periods just as soon as there is an indication that the prior progress is being renewed. Don’t be in too much of a hurry on this. Suppose you cannot point to some action that clearly indicates the prior move is about to be renewed. In that case, you may be setting yourself up to be stopped by a correction that goes a little farther than you had expected or by the consolidation that ends with an unexpected shakeout or upthrust action.
X is an aggressive trader who risks 20% of his account on each trade. Y is a conservative trader who risks 2% of her account on each trade. Both adopt a trading strategy that wins 50% of the time with an average of 1:2 risk to reward. Over the next 10 trades, the outcomes are Lose Lose Lose Lose Lose Lose Win Win Win Win-Win.
Here’s the outcome for X :
-20% -20% – 20% – 20% -20%= BLOW UP
Here’s the outcome for Y:
-2% -2% -2% -2% +4% +4% +4% +4% = +8%
Risk Management in Trading could decide whether you’re a consistently profitable trader or a losing trader.
Remember, you can have the best trading strategy in the world. But without proper risk management, you won’t be successful in trading.
What do we include in the Risk Profile?
- What is the level of Risk-reward ratio we will be working on in each trade? Profile
- What is the maximum percentage of our account we are willing to risk on each trade day or week?
- What is the maximum position size we can use per trade?
Risk Reward Ratio
Risk is defined as The amount a trader is willing to lose on a trade if it hits his or her stop. Calculate risk on trade (size of a stop) by measuring the distance between entry and stop-loss.
The reward is the price distance between our entry and profit points. The trading risk-reward ratio determines the potential loss (risk) versus the potential profit (reward) on any given trade.
How do we measure the risk-reward ratio?
Risk Reward Ratio(R: R) = Total Risk on each trade / Total Reward on that trade
What’s the maximum percentage of our account we are willing to risk on any one or more trade/s?
- Only risk a small amount of your total account per trade. You want to keep your risk low, perhaps 0.5 to 1 percent
- Only risk a small amount of total account per day. This is called a daily stop. Perhaps set a rule that if you lose 3 or 4 percent of our total account in a given day, you will stop trading for that day
- Only risk a small amount per week. This is called a weekly stop. Perhaps set a rule if you lose 5 percent of your account in a given week. you will stop trading for that week
4 Steps to Determine Maximum Position Size
Step1 = Establish the maximum Risk amount per day based on a percentage of account size
Step2 = Divide the maximum Risk amount per day by the average number of trades per day to calculate the risk amount per trade
Step3 = Calculate risk on trade (size of a stop) by measuring the distance between entry and stop-loss
Step4 = Divide the maximum risk amount per trade by risk-on trade to determine the maximum position size
Let’s do it in an example
Maximum Risk percentage per day=2%
Maximum Risk amount per day = Account size* Maximum Risk percentage per day
Number of trades per day =2
Risk amount per trade = Maximum Risk amount per day/ Number of trades per day
Calculate risk on trade (size of the stop) =5
Maximum position size= 1000/5=200 shares
The larger the size of your stop-loss (risk), the smaller your position size (and vice versa).
Visually, it looks like this:
As long as we can stick to the above risk profile defined, we can enter 10 trades, have 5 losers and only 5 winners, and still profit overall.
Active Trade management
Most traders focus too much on their entries as that’s the most hopeful trade stage. But the fact is, your exit determines your profit and loss (P&L), not your entry. You can have a good trading entry, but if you manage your trade poorly and exit at the worst possible time, you can still lose.
Techniques for Risk Management in Trading Summary:
Risk management is a critical component of successful trading, ensuring that a trader can continue to trade another day despite the inevitable losses that will occur. Here are several key techniques for managing risk:
1. Set Stop-Loss Orders:
- A stop-loss is an order placed with a broker to sell a security when it reaches a certain price. It limits an investor’s loss on a position.
- Stop-losses can be based on a percentage of your trading capital, a fixed dollar amount, or technical levels such as below support or above resistance.
2. Use Position Sizing:
- Position sizing determines how much quantity to buy or sell based on how much you’re willing to risk on a single trade.
- Calculate the size of a position to ensure you’re only risking a small percentage of your capital per trade, commonly 1-2%.
3. Risk-Reward Ratio:
- Before entering a trade, evaluate the potential risk versus the potential reward.
- Many traders look for a minimum risk-reward ratio of 1:2 or 1:3, meaning they stand to make at least twice as much on a winning trade compared to what they risk on a losing trade.
4. Diversify Your Investments:
- Don’t put all your capital into one trade or one type of asset.
- Diversification helps to spread risk across various assets and sectors.
5. Follow the “One Percent Rule”:
- This rule states that you should never risk more than one percent of your total trading capital on a single trade.
- This helps to prevent any single loss from significantly impacting your account balance.
6. Implement Trailing Stops:
- A trailing stop is a type of stop-loss order that moves with the price as it moves in your favor.
- It allows profits to run while also locking in gains if the market reverses.
7. Avoid Leverage, or Use it Wisely:
- Leverage can magnify gains but can also magnify losses.
- If using leverage, ensure it is within a manageable range, and you understand the implications if a trade goes against you.
8. Daily, Weekly, Monthly Loss Limits:
- Set limits on how much you can lose in a day, week, or month.
- Stop trading and review your strategy before returning to the market if you hit the limit.
9. Use Hedging Techniques:
- Hedging involves taking an offsetting or opposite position to a primary trade to reduce the risk of adverse price movements.
- Common hedging techniques include options contracts, futures, or trading correlated assets.
10. Continuous Education:
- Stay informed about market conditions and continually educate yourself on trading and risk management techniques.
- The market is always changing; staying informed helps you adjust your risk management strategies accordingly.
11. Emotional Discipline:
- Maintain a disciplined trading plan and stick to it, avoiding emotional decisions.
- Do not fall into the trap of revenge trading after a loss or overconfidence after a win.
12. Regular Review and Adjustments:
- Periodically review your trading history to evaluate the effectiveness of your risk management strategies.
- Make adjustments as needed based on performance and changes in market behavior.
These techniques should be tailored to fit individual trading styles, capital levels, and risk tolerance. It’s also important to have a comprehensive trading plan outlining how to implement these risk management strategies in your trading.
In the next article, I will discuss How to make your own Day Trading Scanner. In this article, I try to explain the 3 techniques for Risk Management in Trading, and I hope you understand Risk Management in Trading. Please join my Telegram Channel, YouTube Channel, and Facebook Group to learn more and clear your doubts.
About the Author: Pranaya Rout
Pranaya Rout has published more than 3,000 articles in his 11-year career. Pranaya Rout has very good experience with Microsoft Technologies, Including C#, VB, ASP.NET MVC, ASP.NET Web API, EF, EF Core, ADO.NET, LINQ, SQL Server, MYSQL, Oracle, ASP.NET Core, Cloud Computing, Microservices, Design Patterns and still learning new technologies.