When people start learning trading, trading risk management is the last thing on their minds. This could also be the reason why over 90% of traders lose money.
In addition, many people talk about risk management in a rather vague way.
Don't risk more than x% per trade
While this may be good advice, everyone trades differently: trade frequency, markets, time frame, etc.
This is why there is rarely a one-size-fits-all answer to the question of proper risk management and the topic needs to be explored a little further.
In addition to risk management, I will also talk about trade management and preparation for trading.
Why manage risks?
When you first start trading, you start learning all sorts of strategies and it's very easy to feel like you have the market figured out.
Financial markets are where you will have to compete with the smartest traders and algorithms, so the likelihood that one strategy you learned on YouTube will significantly outperform the market is very low.
You can never say that the market reached a certain level because the x indicator did so, or moved to this resistance because it tested that support before.
Especially those focused on swing trading are more likely to enter a trade based on fundamentals rather than the crossover of two moving averages that they use to justify the move.
Bitcoin rally from $10,000 to $60,000 due to moving average crossover or MACD crossover?
Of course not. But being able to spot these patterns can give you an edge in the market.
Your advantage can be anything: you can use simple or more complex indicators, price action, option chain analysis, trading based on macroeconomic releases, and so on.
The point is that your advantage gives you positive expected value (EV+).
The expected value simply represents the average of the results over a series of trades.
If you look at the Bitcoin chart over the last couple of weeks, you will see that the market has reacted when touching the POC (volume control point) from past sessions.
Of course, this may be to your advantage; I wouldn't use it that easily, but you can see that it is a repeating pattern and the market tends to react when this happens.
Also, if you don't know what "POC" is, be sure to read this article on volume profile trading.
While you can't "figure out" the market, you can develop a strategy that uses certain behaviors that work most often.
Combining this strategy with proper risk management will allow you to stay in the trading game in the long run.
Fundamentals of Risk Management
Two factors are considered the foundations of risk management. Risk per trade and R.
Risk per trade is simply the amount of $ or % you risk on each trade.
The risk-reward ratio tells you how much risk you take compared to your reward.
For example, a 1:2 risk/reward strategy (also known as 2R) tells you that for 1 unit of risk you will get 2 units of reward. In a practical example, entering a long Bitcoin position at $19,200 with a stop loss at $19,000 and a take profit at $19,600 will result in a trade with a 1:2 risk/reward ratio since your stop loss is at a distance of 1 % of the entry price, and take profit is at a distance of 2% from the entry price.
Conventional wisdom is that you should not risk more than 2-5% of your entire account balance on a single trade. Although this is not true, it is much more complicated than that, and I will talk about it more in this article. Let's say you have $10,000 in your trading account and you are faced with a string of 8 consecutive losses. If you think that eight losses in a row is unrealistic, let's take a look at the table that shows the probability of getting losses in a row over 50 trades based on % probability.
As you can see, a strategy with a 50% win rate has approximately a 50% chance of getting eight losses in a row. Although eight losses in a row seems like a lot and can bring some psychological stress, this does not mean that the strategy is not profitable.
As you can see from this equity simulation, out of 50 random simulations with 100 trades using a 50% win strategy and a fixed 2R per trade, there is not a single simulation that ends up in a loss when using a fixed 2% risk per trade.
Now look at the same simulation with 10% risk per trade. Risking 10% per trade is an almost unpronounceable thing in the trading industry as every mentor/educator will tell you that it is simply too much, but is it true? As you can see, some equity curves reach astronomical figures, but there are also 11 maximum consecutive losses; hitting them early in your run would wipe out your score.
As you can see, by risking 10% of your account to begin with, you'll end up with a 52% drawdown with eight consecutive losses. This is something that many people won't be able to stomach, but for certain traders, risking 10% per trade is still a viable option.
Different approach for different trading styles
We all trade differently based on our strategies, beliefs and timing. Some people make 50 trades a day scalping ticks on the DOM, and some people don't make 50 trades in a whole year. I average about 1-3 trades each day in what I consider intraday swing trading. Does it make sense for me to risk 10% per trade? Not really, since hitting my daily loss limit, which I set at three losses in a row, is not out of the question at least once every week or two. Leaving the table with a score drop of 30% is not very pleasant compared to a drop of 3-6%; Of course, this is also not very good, but it is much easier to bear. This is why it is important to know your strategy and how many trades you are going to make on average every day/week/month and so on. If you are swing trading, make one to three trades per week; risking 2-3% per trade is completely normal. If you only make one to three trades per month, you can risk 5-10% without any problem. Because of this, it can be difficult to follow the conventional wisdom you read about online: never risk more than 2% on a trade, etc.e. You should know your expectations of the market, how active you will be and how much you are willing to risk compared to how often you will trade. For example, let's say you have $100,000 in your trading account, but you only average three trades per month. Does it make sense to strictly stick to 1% risk per trade, or is it better to look at your results and adjust your risk to 3-5% based on equity modeling data? I think the latter is the best choice. The opposite of this would be someone who day trades and gets in and out of trades quickly. Day traders and scalpers must consider additional costs such as commissions and a much higher chance of slippage. In this regard, there is no reason to go crazy with risk, since 0.5-2% per trade is more than enough.
Using a Stop Loss
Stop loss is a trader's best friend; you should always use stop loss
This is often heard, but it is also not entirely true.
A stop loss takes you out of a trade at one predetermined price; once this price level is reached, your trade will be executed at a loss. This often leads to the following situations
But how to get rid of this? The big advantage of using a hard stop loss is that you can easily calculate your position size according to your risk parameters, as well as get clear data when logging your trades. This is why I always recommend that new traders use tight stops. As you become more experienced, you will encounter two scenarios where you may not want to use a hard stop. First of all, I think it is necessary to mention again that you must have experience in the market and trading; if you are new to trading, just skip to the next chapter. In my experience, trading without a hard stop is usually done using swing/position trades.
If you were bullish for some reason and wanted to build a position inside the gray box, you will have a very hard time finding the time for the market to accurately bottom on this weekly chart. Especially after the first weekly breakout candle, which indicated continued growth, but instead led to lower prices, and most likely a stop loss was triggered. What many traders/investors do is they average out within their position and continue to buy until the price reaches a predetermined level where they know they got the trade wrong. While they may not have a hard stop, they may begin to exit the trade and liquidate the position. There are many ways to do this, but this approach is typically found among traders who don't care too much about market timing and prefer to scale their positions using multiple orders. The second practice is to use soft and hard stop loss, which is more suitable for short-term trading. I do this too from time to time, usually when I have a bias on a higher time frame and am executing a trade on a lower time frame.
As you can see in this 1-hour chart of Bitcoin, you may want to enter a short position if the market makes a false breakout (wick higher, close higher) of the previous swing high at support. When you enter a trade, you don't want to see new highs that invalidate your trade, but you also want to have a little headroom to move with. If you look higher, you can identify another level of structure that may be about twice as far away from your original stop. If you place a stop loss at the hard stop level, the risk/reward ratio of that trade will be three if the market hits a new low. If you place a stop loss at the soft stop level, the risk-reward ratio will be more than 5.5. Let's say you have enough experience and know that the market shouldn't hit your stop loss, but 20% of the time it might jump one more time before moving lower. In this case, you can move to lower timeframes where you can set a manual exit rule at your soft stop.
That's why there must be certain rules. First of all, it is only suitable for those who have some experience and know their setup through observation or journaling and knowledge of the markets they are trading in. When I use this approach, I follow the simple rule that the hard stop cannot be more than twice the distance from the soft stop. In other words, if I typically risk 1% per trade and the market quickly breaks out to my hard stop, I cannot lose more than 2% on the trade.
Again, I don't do this with every trade, just the ones where I may either have a higher time frame prone to more movement, or I'm entering at a time of lower liquidity, so some shakeout moves can be expected.
As I said, those new to trading should forget about this right away and only come back to these concepts when they have enough experience/data to support their decision.
Partial fixation of positions
Closed half here, moving the stop to breakeven and letting the rest run risk-free!
I'm sure you've already read about this somewhere. People like to take partial profits because they feel like they have taken something from the market and are now not exposed to any risk.
Using the same trade as in the previous example, you can see that the profit taking is divided into two parts. The first part will be closed at 2.5R and the second at 3.5R. Let's break this down a little. First of all, let's consider that you will not use partial take profits and will close the trade completely at the 3R level. If you had risked 1% on this trade, you would have made a profit of 3.5%. But if you were to divide your take profit into two parts, you would end up with only 2.%. You can treat this as two separate positions with a 0.5% risk. The first closes with a profit of 2.5% (2.5R), and the second with a profit of 3.5% (3.5R). Of course, if you closed only half of the position and then the market turned against you, it would result in a smaller loss, but more often than not, taking partial profits only brings us comfort and does not benefit us in the long run.
Setting Risk Settings
Another thing traders often do is decrease the size during losing streaks and increase the size during winning streaks. If you remember looking at various equity curves, you may have realized that markets produce a random distribution of winners and losers. This is why sticking to your strategy is the most important thing, as you may get bad results in 10 trades, but great results in 500 trades. Anyway, let's say here's your random distribution across 10 trades. You risk a fixed $100 per trade with an R of 2:1. The distribution of profits and losses will be as follows. $200 $200 $200 -$100 -$100 -$100 -$100 $200 $200 $200 This would result in a total profit of $800. As you probably noticed, you had four losses in a row during this period. Many traders would feel unsure about this and would reduce their size by half until they made at least two wins, for example. The distribution of profits and losses would be as follows. $200 $200 -$100 -$100 -$100 -$100 $100 $100 $200 $200 Your total profit will be $600. As with partial profits, this approach is not beneficial to your trading. Instead, I recommend dividing the strategy into different setups and tracking the performance of each setup individually, while setting a “stop trade trigger” for each individual setup you trade. For example, you might say that if your moving average crossover setup suffers ten losses in a row, you will stop trading it, analyze past performance, and try to either improve it or get rid of it completely. This is much smarter than constantly adjusting your position size because you hit a bumpy road. While increasing your position size during winning streaks also doesn't make much sense, you can get into a situation where you trade two setups somewhat systematically since they always look the same, follow the same rules, and so on. Setup A might have a 40% win rate at 2.5R and repeat on average five times a week. Setup B has an 80% win rate at 3R and occurs on average twice a month. Should your risk be the same % or dollar amount under these settings? Not really. Of course, you shouldn't bet on setup B, but if you find that setup B occurs in very favorable market conditions where you can confidently enter the market, you should take more risk. Just don't go crazy.
Breakeven
Most of us are technical traders. We use price action, order flow, indicators, etc. to determine our entries, stops and take profits. All of this technical knowledge is thrown away as soon as we move our stop loss to the least technical level in the trade, which is simply a random entry price point and has nothing to do with invalidating our trade. Breakeven is the same as partial profit; it's a psychological blanket that reassures us that we've "beat" the market today, and we won't leave our desks mad after losing money.
This is one of the most common examples of ruined trading that I am 100% sure has happened to you in the past. You hit a support level while targeting the next resistance level; nothing complicated.
After entering a trade, the market instantly puts pressure on you; After some time spent in the drawdown and nervous about possible losses, we finally rise higher. At this point, you move your stop loss to breakeven because you don't want to go through the discomfort of losing money again.
The market immediately returns to your entry, taking you to breakeven and rushing towards your target. Was your trade invalid because you broke even? No, you were just afraid of losing money. Instead, you should move your stop loss according to your strategy and invalidate the trade.
Leverage
In the trading industry, when something goes wrong, leverage always takes the blame. Retail traders are blowing accounts left and right, and it's always because of leverage, not poor risk management or greed. So what is leverage? Leverage is related to margin. Margin is the money you borrow from your broker to open larger positions. You can often find leverage of 1:10, 1:30, 1:100. If you use 1:100 leverage, you will only need $1,000 to open a $100,000 position in Bitcoin. The problem comes when the price of Bitcoin starts to move against you. Let's say the price of Bitcoin is $50,000 and you bet 2BTC ($100,000) using a margin of $1,000. If Bitcoin falls 1% to $49,500, your position will be liquidated and you will lose $1,000. Of course, in Bitcoin's move to 1% is nothing unusual. These massive retail liquidations have been the subject of much regulation and discussion in recent years, not only in crypto but also in traditional markets where all products are highly leveraged. On the other hand, if your brain cells are working, you know how to manage risk and position your trades correctly without being greedy, you will never have such problems and you can start using leverage to your advantage. Exchanges go out of their way to be your best friend, especially in cryptocurrency, where CEOs mingle with ordinary people, influencers foster collaboration, and generally do their best to make sure that's where you trade. And why not, if more than 80% of retail traders lose their money, and the exchange makes money on it? This is where you can use leverage to your advantage. You should never forget that exchanges can go bankrupt in an instant, especially those that have fewer regulations and offer dubious trading tools.
Moreover, you, of course, can be hacked, funds stolen, and so on. But if you can use 1:30 leverage, you don't need to have that much money on the exchange. Let's say you are trading with an account of $100,000. If you are trading Forex, where one standard lot is equal to $100,000 with a leverage of 1:30, then you will only need $3,333 in margin to open one lot. Thanks to this, you can keep a relatively small amount of money on the exchange. I usually keep about 20% of my account balance on the exchange; this is more than enough to cover margin requirements, and although in the eyes of the exchange you are risking 10-20% on each trade, it does not matter. If the stock market crashes, of course, it will be a shame to lose $20,000, but it’s much better than losing $100,000.
Transaction journal
Throughout this article, you may have noticed how important it is to rely on statistics as your guide to properly allocating risks. In this article I talked about my favorite magazines. Let me briefly remind you what indicators are important for journals: Tool Trading Setup Entry/Exit/Stop/R Prices: R and PnL Maximum Unfavorable Deviation (MAE) Maximum Favorable Deviation (MFE) Screenshot of your trading setup Keeping a journal is not very fun, especially on losing days . The last thing you want to do is sit down and relive the moments you screwed up, but it's worth it. One of my favorite things to do during bad periods is to go through my journal and look at my winning trades, comparing them to my current losing trades, to see if I'm making any mistakes or if I'm just in unfavorable market conditions. Additionally, logging will not be the same for everyone. If you are a scalper and make more than ten trades in one session, you will go crazy if you write them all down. One of the huge benefits of some of the journals that I mentioned in the article is the automatic import of trades via API or broker statements; this way you will collect data without manually entering trades. If you are scalping, I would recommend that you record your screen while trading and keep a journal of the day in general, how you performed, how you felt and so on, as intraday scalping tends to be a more discretionary approach. Make journaling a routine, take a screenshot of each trade after it's completed with annotations and log it. I record my trades on Wednesday and Saturday, but you can choose any time that suits you.
Start with a small account
So now you know most things about risk management and are ready to trade, but you don't have much money. When people ask me, I usually answer that it is not worth trading with proper risk management if you have an account of less than $10,000 or a risk of at least $100 per trade. This can be a harsh truth because most people can only afford to start swing trading with $2,000 or $5,000 while holding a day job. A 3% risk on $2,000 is $60 per trade; this will lead to a tendency to over-risk because you will see some results, but they just won't be enough. Although there are often crazy stories on the internet, setting up an account with a fixed and conservative percentage risk per trade takes time. Instead, you must risk a fixed amount of $ or the contract size per trade, which is slightly higher. Again, all this must be backed up by some experience; if you're a beginner, you can demo trade or just put in a really small amount of money and risk 1-2% per trade for a few months to gather data. Collecting data is a very important part because you will know your statistics, how many losses in a row you can incur, and your risk of ruining your account. If you have this data, then the optimal period of profitability is from 3 to 6 months; you can apply fixed ratio risk management. In short, you set a fixed $ amount or contract amount as your risk for each trade and increase it when you increase your account by a certain amount. Let's put this into practice: Let's say you start day trading Emini S&P500 futures with an account of $5,000 and trade one contract. Your average stop size is 3 pips, which is equal to $150 or 3%. Of course, this is a little high for day trading, but since you are backed by data and keeping a log of your trades, you know that the risk of blowing this account to zero is very small. If you can get it to work, you'll only need 3-4R to get a 10% score boost. This way you can double your account quite quickly. Once you double your account, you will also double your trade size to 2 contracts. So now you're risking $300 per trade on a $10,000 account, which is still a little high for day trading, but it's not crazy and it builds on what you've gained, which will improve your psychology as you earn this money. You can continue to do this until you feel you have enough capital to risk only that desired 1-2% per trade. I cannot stress enough how important it is to know what you are doing and to be 100% confident in your trades. You can achieve this with backtesting, but usually backtesting results are too promising compared to real trading.
Psychology of Trading
I feel like this post wouldn't be complete without a few words about the psychology of trading, as this is what many people rely on and what they usually blame themselves for when they lose money. We as humans can be quite complex and I can't speak for everyone based on personal experience alone. Since I've been doing this for a while, I went through a period where I read some books about trading psychology, listened to podcasts, meditated, etc. No doubt all of these things can be useful, but I have never found any real trading help. If you wake up and meditate for 20 minutes every day, you may become less of a pain in the ass for your closeted one, but trading is about pushing buttons, not sitting in the corner. Anything you think is to blame for your poor psychology is usually just due to insufficient screen time and experience. We live in crazy times where everyone is an internet millionaire (more on that in this article), but trading is about hard work, screen time, and sticking to your rules, no matter what people on the internet tell you. Because I don't want to judge trading psychology too much, I know that most new traders lean towards it instead of looking at charts and trading. This, in my opinion, is a huge mistake because you can gain the most experience from trading the markets rather than from courses, books or podcasts.
Preparing to trade
One of the best things I've ever read about trading is this:
Every day you start from scratch.
It doesn't matter whether you lost or made money yesterday, it's a new day and you should focus on it and not on your previous wins or losses. What helps me a lot is preparation in the morning or the night before.
Daily timeframe
Daily supply and demand zones
Checking lower time periods
TPO
Abnormalities
What happened last session
Beginning of the American session
Inside the day's plan and scenarios
In the end, it doesn't matter how you do it, but what you will find once it becomes a habit is that you will begin to remember what the markets are doing and will be well prepared for each trading session. Again, this may be more suitable for day trading; if you are a swing trader and only do a couple of trades a week/month, your preparation may be more focused on setting alerts/placing limit orders and so on.
Conclusion
Risk management is a simple thing, but can be very discretionary and complex. I hope I've covered the basic concepts and what you won't find in conventional wisdom. We are all different, with our lifestyle, account balance and approach to trading. Therefore, there is no right or wrong answer to the question of how to properly manage risk. Very often you can hear that trading is not a sprint, but a marathon. That's true, but I'd rather say that trading is about collecting data and building confidence in what you're doing through screen time. Your job as a trader is to show up tomorrow; there may not be a tomorrow if you bet on the house.
#training#risk#management #riskmanagement
