Risk Management: What Is It and Why Should I Use It in Trading?

a year ago

What Is Risk Management?

Risk management is a technique, or a set of techniques, to reduce losses and protect traders like, say, Jake from losing their accounts completely and having to get back to work at Mcdonald's. For the sake of explanation, Jake is a 24-year-old novice trader who is trying to set up his risk management approach.

As we discussed last week, sometimes trading is more about survival than making money. By managing your losses, you are protecting yourself against adverse market events. A lower risk will also limit the size of your wins, but if you build your account slowly, the compounding effects will kick in eventually.

How Do I Use Risk Management in Practice?

There are three pillars of risk management:

How much money are you willing to risk on a single trade? (define risk)

How much money are you going to trade? (portfolio size)

How much money do you use on a single trade? (risk-reward)

Let’s look at them one by one.

Defined Risk: How Much Money Are You Willing to Lose on a Single Trade?

Defining how much of your portfolio you are going to risk on a single trade is a crucial step in risk management. You want to be able to take multiple losing trades in a row and survive.

Many traders, therefore, choose to limit their risk to a single percent of their total trading portfolio, so that they don’t lose too much of their stack in those losing streaks.

It is important to define how much money you will risk. We often use the following example: a losing trade should be similar to the amount that could buy you and your significant other a dinner out in your town.

As an example, let’s say Jake wants to cap his losses at a maximum of $100, risking 1% of his portfolio per trade.

Portfolio Size: How Much Money Are You Going to Trade?

Step two on the risk management journey is defining the size of the portfolio you are going to trade. Most seasoned traders keep their long-term assets separate from the stack they are trading. This allows you to look at your portfolio objectively: you can leave your long-term bags to do their thing while focusing on active trades.

Defining how much money you want to trade is a tough nut to crack. This author believes the size of your initial portfolio should be determined by the approach we set out in the previous section.

If we look at Jake’s decisions, we can easily calculate the portfolio size he needs. By multiplying his maximum losses by 100, he learns that he will need to fund his portfolio by $10,000.

We multiply it by a hundred because he caps his risk at 1%. You may multiply it by 200 for a 0.5% risk. You may change the size of the account by changing the risk figures. Just make sure to keep emotions into account!

Risk-Reward: How Much Money Do You Use on a Single Trade?

Now that we know Jake's portfolio size and his maximum risk capacity per trade, let’s discuss risk-reward and position sizing.

Firstly, risk-reward is the ratio of Jake’s potential winnings (reward) relative to the $100 he wants to risk. Your risk-reward ratio should ensure you trade profitably, considering your average win rate. With a win rate of 50%, Jake should take trades of at least 1:1 risk to reward. Higher rewards to risk will make him profitable.

Different strategies may have different win rates, so be sure to adjust your risk/reward ratio and corresponding position sizes accordingly.

Tradingview has built-in long and short position tools to help you find trades matching that risk profile. As you can see, the Ethereum trade above has a risk-to-reward ratio of exactly two.

This tool is also able to help you determine the size of your position. By double-clicking the trade we just drew, we can provide the tool with all the necessary inputs. As you can see, we’ve filled in Jake’s account size of $10,000, and the risk is set to 1%.

After giving the tool these inputs, it will tell you the position size (in units or shares) for the trade you’ve drawn. You will be able to see the effect of both the winning and losing outcome. In this case, Jake can take the trade with a quantity of 14.38 Ethereum. If he is right, he will make $200. However, he will lose just $100 in case he is wrong.

Having clear winning and losing goals defined based on your performance from the beginning makes trading easier. As long as you stick to your plan religiously and keep tuning it based on changing win rates and account sizes, your account will grow.

Closing thoughts

Risk management protects you against adverse market events and ensures your survival. It allows you to trade using a very systematic approach and grow your trading account.

Remember that you must track your performance over time to manage risk accurately. Journaling your trades is a good practice and will help you significantly.

Writer’s Disclaimer: This article is based on my limited knowledge and experience. It has been written for educational purposes. It should not be construed as advice in any shape or form.

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