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Becoming a Better Trader – Principles of Risk Management (Video)

Becoming a Better Trader – Principles of Risk Management (Video)

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Risk management is at the core of any good trading plan, without having a sound set of principles to follow a trader is doomed to fail. We outline rules and factors to consider when customizing a risk management game-plan right for you.

We understand the difficulties of trading, which is why we’ve put together a variety of guides designed to help traders of all experience levels.

Risk management is paramount to success

Risk management is one of the most important aspects to successful trading, but far too often it’s overlooked. Job #1 for a trader is to always keep yourself in the game. A sound strategy and the discipline to follow it will go long way towards ensuring you stick around.

If you are in the learning stage, your objective is to keep losses very small until you figure out what you are doing from an analytical and strategy standpoint. Adhering to sound risk parameters early-on will go a long way towards building a foundation for later on.

For the more seasoned trader, your goal is to avoid digging unnecessary holes and of course avoiding the risk of ruin. Maybe you have a workable strategy, but perhaps are inconsistently applying rules related to risk management which are impacting your ability to grow.

Whether you are a new trader building a foundation or an experienced trader struggling (it happens to the best), here are some ideas for Building Confidence in Trading

Individual trade management

How much capital you risk on a trade is dependent on your own risk tolerance. This varies from trader to trader, and is vital that you trade with a size which doesn't impede your ability to make good decisions. Trading with too much size is often times the culprit for poor didscipline in seeing a trade through as planned.

Trading size based on percentage at risk

First off, it's a good idea to think in relative terms rather than absolute. Think of what percentage of capital you want to risk, not how many pips or points. Your trading size will be dynamic when taking this approach. Let’s say you risk 1% per trade, the trade size will be twice as large on a trade with a 50 pip stop versus a trade where the stop is 100 pips away. If you keep your trading size dynamic in this case your risk will stay the same. If, however, you think in terms of fixed lot sizes, then over time the risk will vary and so will your results.

For example, let’s assume you have an average win/loss ratio of 1:2. If you risk 50 pips on trade #1 and make 100 pips (2x risk), then you will be ahead by 100 pips. But on trade #2 you risk 100 pips and it hits your stop, you will lose 100 pips. This will result in a net of 0 between the two trades if you trade in absolute lots sizes.

However, by taking a dynamic approach and adusting your trading size to fit your percentage per-trade-risk you will have a profitable outcome in this scenario. Let's say you risk 1% on trade #1 and make 2%, and then risk 1% on trade #2 and lose, you will still come out ahead +1%. It’s a simple example, but the principle should be clear.

Your 'risk-per-trade' should be in a relatively tight range

You want to be consistent with the risk-per-trade. You don’t want to risk 0.5% on one idea, then 3% on the next, then 1% after that, and so on. Like with using fixed lot sizes, your results will be all over the map. Perhaps you are extremely confident on an idea and want to risk a little more than usual, that is fine as long it doesn’t vary too greatly from your normal trading size. Typically, good set-ups don’t have as much of a variance in probability of success from one to the next as one might think.

A high win percentage shouldn’t be the primary goal

Your primary goal should be to find trades which give you an edge and offer an asymmetrical risk profile. Risk/reward should be around 1:2 or better. Too many traders get hung up on having a high win percentage, which is understandable to a degree – people don’t like to lose, but that is part of the game. It is better to have a 30% win rate with a 1:5 R/R ratio, than a 60% win rate with a R/R ratio of 1:1.

Factors pertinent to determining trade size

When determining how much to risk on a trade, you have to consider the fact that you will inevitably have a string of losers, and how long that string will be is often dependent on your trading style. For example, breakout/momentum strategies typically have lower win rates, but high risk/reward ratios. On the other hand, a range or mean reversion strategy will have a higher win rate, but lower risk/reward profiles.

It’s quite possible you could have 10 losers or more in a row, and with that said, losses can pile up quickly. One needs to factor in the total string of losers and how big it could potentially be (this ties into account management which we will discuss soon…)

Trade frequency is an important factor to consider. On one end of the spectrum, if you hold trades for several weeks, you trade with far less frequency and thus can risk more per trade. While on the other end, if you are a day-trader, then your risk-per-trade needs to be much smaller as losses can pile up in a very short period of time.

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Hard stops are prudent

A ‘hard stop’ is simply a stop-loss which is entered in to the trading system, versus a ‘soft stop’ where you have a pre-determined level in mind that you will exit should it get triggered. Three reasons to use a 'hard' stop. One, you don’t need to be sitting in front of your screen all the time, or when away wondering what is going on with your position. Two, there is an element of discipline instilled by having that ‘line-in-the-sand’ drawn ahead of time. Three, you never know when an unforeseen event will happen and you are caught holding the bag.

Account risk management

Risk-per-trade is just one element to a good risk management plan. You also need to protect the overall account by considering a couple of factors. These obviously circle back around to per-trade-risk, but from the perspective of looking at the whole.

Take into consideration correlated positions

This is an overlooked factor which can sneak up on a trader quickly if not careful. If you are trading several currency pairs or markets which are highly correlated, trading size per position needs to be adjusted to reflect such.

For example, if you have on 3 JPY pairs which are in the same direction, then it is prudent to treat that as one position and assume all three positions could hit their respective stops. The same goes for negatively correlated markets, such as the dollar and gold. If the two are trading in opposing directions (which often times they are) and you are, say, long the dollar and short gold, then the risk of the two moving favorably or unfavorably together is high. Again, you want to consider the total risk attached to that theme.

Have a maximum drawdown number in mind

When trading isn’t going well, at what point over a period of time do you temporarily pull the plug? You need to set a limit as to how much is too much. Drawdowns are an inevitable part of trading and understanding how to handle them is crucial to maintaining your account equity. This, like trade size, varies from trader to trader. Is it 10, 15, 20%? That point where you say, “You know what, I need to take a step back.”

The first step when a max drawdown is hit, is to do just that – take a step back. Get out of the fire, so to speak. You will immediately feel relief by doing this. It’s only after you’ve gotten yourself away from the screen can you see what is going wrong from afar and then put in appropriate fixes.

Once you’ve identified and put in a fix, don’t come back ‘guns-a-blazing’. Ease back into trading with a much smaller trading size, say 25-50% of the norm. The objective is not to make all your money back right away, but rather to restore confidence and turn the ship back in the right direction. Once you have confidently done so, then increase trading size back to a normal level. Check out the "Building Confidence in Trading" guide for more on restoring confidence.

Trading around high impact fundamental events

For existing positions, if based on technical analysis, then holding around a major announcement is pretty standard. Just make sure to have your protective stop in place and adhere to it. If the event is very near and a trade triggers, you may want to consider holding off until after the event, or at least reduce your trade size.

For the full conversation, please see the video above…

Past recordings you might be interested in: Creating a Trading Plan; Handling Drawdowns; Analysis, keeping it simple; 6 Mistakes Traders Make; Focusing on the Process; Building Consistency; Classic Chart Patterns, Part I; Classic Chart Patterns, Part II

---Written by Paul Robinson, Market Analyst

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DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.