Trading is a game of risk and returns. The balance between them defines your trading style and your chances of success. This is also where the main problem lies. The first question on a beginner trader’s mind is how much I can win on this trade. That’s the wrong attitude. It should always be, how much can I lose? Trading risk management helps maximize your potential gains while also minimizing your potential losses.
In this guide, we will find out what trading risk management is. We’ll also examine how it can help you grow in your trading career. Finally we’ll go over the best tools for this purpose. Let’s get started!
Trading risk management is an overall strategy to minimize your losses and protect your trading account’s capital. It is an invaluable tool in any successful trader’s arsenal and the foundation for building a successful trading plan. It is also crucial to every hedge fund, trading firm, or large-scale investor.
Risk management is basically a viewpoint that considers everything that can go wrong while trading. It looks at what can make your capital vulnerable to losses. It tells you how to proceed in each situation to better protect your assets.
If trading is a house, then risk management is its foundation. It defines how successful your trading strategy will be. This helps you determine whether you will be able to survive the competitive environment of today’s financial markets.
Trading risk management doesn’t concern only losses. It also defines the reasonable profit target you should aim at without worrying about your portfolio’s stability.
It is also essential for market participants looking to invest in a particular fund, for example. Among the primary tools that help them find the optimal investment opportunity is the so-called Sharpe Ratio. This helps investors understand the return of an investment compared to its risk. Alternatively – how effective the risk management strategy of the fund is.
A high Sharpe Ratio is preferred since that means the fund has managed to achieve good returns without taking on excessive risk.
Why is Trading Risk Management Important?
Risk management is important because knowing when to trade and when to close your positions will determine your long-term success.
Many traders start from the idea that wins are more important than losses. Alternatively, if your wins exceed the number of your losses, no matter how big they are, you will be successful.
However, by itself, this isn’t viable in the long run. If you look at the most successful examples from the trading and investing world, it’s people and institutions that reached the level where they’re at by carefully weighing their options and only opening a trade at the right opportunity.
This type of accomplishment can require several years or even decades. You always have to remember that the financial markets are cyclical in nature. This means traders who have a history of sustainable profitability have successfully made it through bear markets or crises.
This means they can preserve their capital in periods of volatility, market destabilization, political and economic crises, and other potentially harmful events.
Let’s assume we have two traders named Joe and Bill. Both end the trading day with a profit of $100. Joe managed to get it with just two highly-profitable trades. Bill did it through 20 trades. Who do you think has a better risk management strategy?
The answer in most cases is Bill. The reason being that he aims at lower but less risky and more easily obtainable profits. Joe, on the other hand, is more of a risk-taker. He might manage to make $100 in just two trades. On the other hand, he could lose the same amount or more next time if things don’t go his way. The bottom line is that Bill’s strategy is more sustainable and predictable.
One key to being a successful trader is the ability to estimate and control risk. If you manage to do that, it will allow you to build a strategy that delivers relatively consistent returns and is resilient to market disruptions.
Without a proper risk management strategy, a retail trader is basically bringing a knife to a gunfight.
How to Manage Trading Risk?
The best way to manage trading risk is to identify as many risk factors as possible that might affect your portfolio’s health before you start trading.
This can’t be overstated. By marking down all the potential threats to your investments, you will be prepared for most of what could go wrong and develop a backup plan. Knowing how to react in these situations will help you stay calm and keep your emotions in check even in the heat of the moment. It’ll give you the confidence to know that your strategy is based on well-researched and thoroughly tested information.
Let’s illustrate this with another example. Assume that you are a futures trader that wants to specialize in energy commodities. To build the foundation for your trading risk management strategy, you will consider several factors that affect price, including, but not limited to:
Market specifics – think of seasonality might increase the demand during the winter or decrease it during the summer.
Political risk – find out where these commodities are produced and who are the biggest consumers. Be cautious about international restrictions or import/export deals that might disrupt the market.
Intraday trading factors – find out how these commodities behave when the leading markets are open and closed. Study their reaction to news coming out overnight to know what to expect when markets open.
Trends in competing markets – if you are trading fossil fuel futures like crude oil (CL), keep an eye on the renewables market. Any developments there impact the price of conventional energy commodities.
Black-swans – although you can’t be prepared for these events, learn how the market you are interested in has performed in the past around situations like the COVID-19 pandemic, an oil spill somewhere around the world, etc.
Of course, there are plenty of other factors that you should take into account and prepare for, but this is a good start. Make sure to expand this list with all the known risks and threats that might affect the price of the asset you are interested in.
Once you are done with this step, it is time to get more practical and learn how to…
Plan Your Trades
A trading strategy for financial market participants is what training is for athletes, and rehearsals are for musicians and actors. Successful traders never underestimate this step.
Many beginners are impatient and want to get out in the trading world as soon as possible. This is a recipe for disaster. Bear in mind that if you don’t have the right preparation, you will exit the market quickly as you have entered it.
Spend as much time as needed to plan your trades and become confident in your strategy. Make sure to test it with paper trading first to validate its weaknesses and address them without risking real capital.
Every battle is won before it is fought.”
– Sun Tzu
The phrase “plan the trade and trade the plan” basically sums up what most beginners should do. Although pretty self-explanatory, it’s not necessarily easy to apply it in real life.
First, think about your trading style and plan the frequency of your trades. Figure out whether you would be making a couple of trades per day or a single one per week, for example. This is essential because it will determine how your strategy will work and what risk management factors it should incorporate.
Also, you should find a broker that is suitable for your trading style and needs. When you are a day trader, you will be seeking a broker with low trading fees. If you are an investor in alternative assets, you would be looking for a broker with a large set of exotic product offerings. If you are a beginner with limited capital, you might want to start with a service provider that offers commission-free investment opportunities. More demanding traders would be looking at brokers with renowned platforms and rich analysis features.
Once you are ready to go, make sure to plan your profit targets and the rules, your strategy should abide by. Alternatively, come up with a plan – when, where, what, and how to trade. The rules you come up with will be the cornerstones of your strategy.
The One-Percent Rule
The one-percent rule suggests that you should never put more than 1% of your capital on a single trade. It ensures you are making reasonable trades without taking on too much risk while chasing big profits.
That cotton trade was almost the deal breaker for me. It was at that point that I said, ‘Mr. Stupid, why risk everything on one trade? Why not make your life a pursuit of happiness rather than pain?”
Although this idea sounds reasonable, you would be surprised by how many traders fail to stick to it. The reason is that, often, we spot an opportunity that seems lucrative, and we try to leverage our potential return. However, it could take just a single instance where the market proves us wrong to get wiped out. That’s why it’s crucial to remember the importance of the one-percent rule.
The one-percent rule is among the more popular and widely practiced rules for beginner traders and individuals with limited capital. It promotes self-control and sound risk management.
According to the one-percent rule, if you have $1,000 in your account, you should place no more than $10 per position.
The key to being profitable when applying the one-percent rule is in the number of winning trades and not their individual amount. For example, aim for making 5 winning trades where you risk 1% on each position, instead of one winning trade, where you risk 5% of your capital. In the long-term, this has better chances of reaping a profit and preventing substantial losses.
Some traders modify this rule by increasing its high-end limit to 2%. However, this usually isn’t advisable if you are a beginner or a trader who is still building and testing their risk management strategy.
The idea of position sizing is simple – never risk too much capital on one position.
Using Stop-Loss Limits
Some traders compare stop-loss limits to having a life vest or a safety net. The idea is that when you set a stop-loss limit, you will be able to control the amount you can potentially lose on any trade.
Stop-loss limits are applied through specific orders to place a mechanism that will sell your assets once they reach a particular price level. If the instrument’s price remains above it, the stop-loss limit won’t trigger, and your position will remain open.
Through stop-loss limits, traders can automatically close positions when the market turns against them. This way, they can prevent losing more than they are willing to. By incorporating stop-loss limits into your trading strategy, you ensure your peace of mind even if unable to monitor the market 24/7.
To take advantage of stop-loss limits, you should define what price you would like to sell at. Alternatively – how much loss are you willing to take before closing your position to prevent further capital loss becomes unavoidable.
A stop-loss order benefits every market participant – from the scalper and the day trader to the long-term investor. It helps protect against sudden high volatility, black-swan events, news-driven market drops, and other unpredictable scenarios by mitigating your losses.
However, they can also be used to lock-in profits. This is especially important when you’re dealing with something like a trailing drawdown. In that case, unrealized profits could very well turn into a liability. With that in mind, let’s move on to the next point…
Using Take-Profit Orders
Take-profit orders (T/P) specify the exact price you would like to close a position and capture a profit. If the specified price level isn’t reached, the T/P isn’t triggered.
Take-profit orders are very similar to the stop-losses in the sense that they allow you to close your position when predefined conditions are met.
The main benefit of take-profit orders is that the trader won’t have to worry about their unrealized profits suddenly turning into a liability when trading an account with a trailing drawdown. Thanks to that, you can have the comfort of not monitoring the market 24/7, knowing that the T/P will close your position should the price level is reached.
T/Ps are often used in conjunction with the stop-loss orders. That way, the trader can ensure total control over their positions. They are capable of keeping the performance of their investments within certain boundaries. Should the instrument’s price go below the S/L level, the position will be closed, and the trader would cut their losses. On the other hand, if the price suddenly spikes above the T/P level, the trader could still pocket their drawdown.
Take-profit orders are used mostly by short-term traders and speculators who have to time their moves perfectly.
Determine Your Risk/Reward Ratio
The risk-reward ratio tells you what reward you can expect for every dollar you risk on an investment. For example, if the risk-reward ratio is 1:3, you can expect to earn $3 for every single dollar you risk.
We used this particular figure because, in general, approximately 1:3 is indeed the optimal and most reasonable risk-reward ratio. Alternatively – one unit of risk should guarantee three units of return. However, this can depend on the trading strategy and the trader’s risk appetite.
You can also look at it as the difference between the market price and the limits orders placed at the profit and loss levels on either side.
Traders use the ratio to find out which are the best opportunities in the market. A well-defined risk-reward ratio means the trader knows what to expect from a particular trade even before it occurs.
Other Trading Risk Management Techniques
Trading risk management is almost a complete field of study in and of itself. There are hundreds of essential books on the topic, and most traders spend their entire careers trying to master efficiently handling risk.
Understandably, we can’t cover everything in this guide, there are a few other essential building blocks for efficient risk management. First, let’s take a minute to reflect on the importance of staying true to the principles of your trading strategy.
In other words, to control your emotions and don’t over-extend yourself into chasing trades that might only appear rewarding. Even if luck is on your side every now and then, you will regret letting your emotions take over in the long-term. Never forget that you have a reason for using your strategy, and going against it is like walking onto an open road with a blindfold on.
Using Paper Trading
Also, it is crucial to always test your risk management strategy with paper trading first. This is your training ground, and if it fails to deliver there, it will be a total disaster when you go live. However, the difference is that, in the latter scenario, you won’t have a safety net, and a failing risk management strategy will cost you money.
Naturally, don’t rush into trading on leverage before you have at least some experience under your belt. Although it might be tempting, if not managed carefully, and if not backed with enough knowledge, it might wipe out your capital in mere minutes.
Also, make sure to keep a trading journal with records of your trading history. That trading data will contain many valuable insights that you can analyze. Keeping a trading journal will help you go over your past trades and check how and why it worked out that way, what you did right, and what you can improve upon. Developing an introspective attitude will make you a better trader.
How Much Can You Improve Using Trading Risk Management Strategies?
No statistics or data can quantify the exact answer to this question, but to help paint the difference, let’s say that trading without a risk management strategy isn’t trading at all. It is more like playing a game of roulette.
Do casino players have a risk management strategy? What about those betting on football matches? Some do, but in most cases, they don’t. They might recognize some patterns and make a few educated guesses, but the rest is just luck.
The difference between a trader with a risk management strategy in place and one without is night and day. The truth is no trader without a proper risk management strategy in place can survive the harsh environment of financial markets in the long-term.
Throughout my financial career, I have continually witnessed examples of other people that I have known being ruined by a failure to respect risk. If you don’t take a hard look at risk, it will take you.”
– Larry Hite
Having a risk management strategy puts some of the control over your positions back in your hands. Without it, you simply rely on the market to turn into your favor which rarely is the case.
Considering that even traders with decades of experience or firms with whole risk management departments of finance gurus and economists with PhDs can’t always predict how beat the market, the chance that a trader without any strategy in place will manage to do it is practically 0%.
Due to the financial markets’ complexity, even if risk management strategies can’t guarantee 100% success. Yet, they give you the best chance to succeed and ensure you have done everything in your power to better protect your investments.
Differences Between a Good Risk Manager and a Bad One
The main difference between a good and a bad risk manager is consistency. To ensure more stable returns, a successful trader doesn’t neglect their risk management strategy and often seeks ways to improve it. On the other hand, a trader who fails might often go against the plan and expose their capital at risk.
Of course, there are many other essential differences. Some of them include:
Good Risk Manager
Bad Risk Manager
Has a plan and sticks to it
May ignore the plan and even go against it
The risk management is tested and proven to work
Goes in the wild without proper backtesting of his strategy
Is calm and composed
Focuses on minimizing the losses
Focuses on maximizing the profits
Uses T/Ps and S/Ls
Doesn’t hedge and may leave open positions unattended
Considers trading costs and incorporates them into the risk management model
Doesn’t care about trading costs
Realizes no one is bigger than the market and trades responsibly
Can get carried away by a few winning trades and overestimate his abilities
Understands the importance of position sizing
Makes risky moves that can significantly decrease his capital
Always looks for ways to improve his risk/reward ratio
Ignores the risk/reward ratio
Is careful when trading on leverage
Trades recklessly and puts his portfolio at risk
Keeps a trading journal and is willing to analyze his past performance to find what can be improved
Cares only for the potential profits that lay ahead and doesn’t focus on what he has done right or wrong in the past
Listens to others and is self-reflecting
Thinks his approach is the best
Isn’t affected by a series of losing trades
Let’s emotions take over when going through a rough patch
Diversifies and hedges
Puts all his eggs in one basket
Trading risk management is a fascinating, deep, and challenging practice. It takes a lot of hard work, effort, and experience to achieve mastery, but, in the end, it’s the same with everything else in both life and trading. If you don’t have the time necessary to do your research and invest in learning and improving your risk management techniques, it is better to stay on the sidelines.
If you want to become a successful trader, there are no shortcuts – you need a sound risk management strategy that will protect your capital and ensure the sustainable accumulation of steady profit. In the end, just know that every minute and every bit of effort invested are worth it because the thrill of being successful in the markets is like nothing else.
In case you want to improve your trading skills even further and learn more, you can also take risk management classes.