Risk comes from not knowing what you are doing – Warren Buffett
The longer you survive in the markets, the more you understand how Risk Management (and all its’ branches such as Money Management, Trade Management, etc) is the most important thing. Having your risk management vehicle well structured may very well be considered the Holy Grail of trading.
I would be surprized if most traders nowadays don’t incorporate a few risk-management components into their trading such as:
- Adequate Position Sizing;
- Always using a Stop Loss (which is a requirement for position sizing anyhow);
- Trying to select trades with favourable reward-to-risk ratios;
- Only trading with money you can afford to lose.
In this article we will connect everything together, and go beyond these basic considerations in order to help you create your own risk profile from A to Z.
Step 1: It starts with Money Management
Starting from the top, the capital you allocate to your trading account should be money you can actually afford to lose. Not all aspiring traders can truthfully say they are trading with risk capital. Trading is a tough job, where you’re up against other experienced professionals. Most aspiring traders lose 90% of their capital in 90 days. Be different. Be smarter.
It’s beyond the scope of this article to dig into financial planning but here’s the broad overview. It may be too conservative for some people that have high incomes and can afford to risk more, or it may be too complex for some people that have lower incomes and very few choices. Based on your situation, think about what is best for you:
- Liquidity: ensure you have 2-3 months’ worth of expenses readily available. This means keeping some in physical form (cash at home) and in your bank account.
- Security: the second step is to ensure you are protected against large expenses that would decimate your account. We’re obviously talking about insurance policies (health insurance, car insurance, house insurance) but also something like Fixed Indexed Annuities.
- Capital Preservation and Appreciation: this is the step people commonly refer to as “investments” or “asset allocation”. Passive investments that are meant to protect from inflation and offer low but consistent protection. Short-term money market instruments (3-6 mth deposits up to 2 yrs) are one vehicle that will likely never go out of fashion even if issues in the bond markets were to appear down the road. Asset allocation plans (like Ray Dalio’s popular All-Weather solution) are also included in this step. The trader Robert Carver (whom we did a webinar with) wrote a good book on creating a decent asset allocation with cheap ETFs called Smart Portfolios and it would be a decent starting point.
- High Risk/High Reward Component: this is where Long/Short equity positioning would come into play, alongside real estate (buy to let or other solutions), and any pure alpha endeavours (i.e. trading).
Your savings account is NOT your risk capital. Your risk capital for trading should be weighted within the overall picture. Identify a sum you can afford to lose, and at all times remember that if you lose it you’re out of the game.
So let’s imagine you’ve got AUD 10.000 to risk, and you have proven yourself on a demo account for at least 3 months. What’s the next step? I believe in deploying risk capital based on merit. Initially, deposit 10% of your risk capital with the broker. That would be AUD 1000 in our example. You will start trading with microlots most likely, but there are certain benefits:
- you will be “almost” demo trading, because the amounts will initially be quite small, so psychological pressure will be minimal
- you will still have 90% of your risk capital in the bank in case your broker defaults
If, after the first month, your results are positive, you can bring another 10% into play during the second month hence increasing your bet size. Refrain from adding to the account if you’re at a loss after the first month. For sure, revisit your model and try to understand what differences there are between the successful demo trading (which allowed you to progress onto live trading in the first place) and your first month of live trading. Using an independent trade journal service (TraderVue, FXStat, Myfxbook, etc) will help with this task.
The objective is to deploy your total risk allocation over the course of your first year of trading based on:
- the amount of risk capital you possess (the larger it is, the more you can dilute it)
- your trading results (only add if your trading is convincing)
The bottom line is that your account balance will grow alongside your experience level, and you give yourself more time to survive, trade and learn. It becomes increasingly difficult to run out of risk capital after a series of losing trades.
Step 2: Risk Limits
Risk limits will not help you if you have no edge. Risk limits will “limit the damage” for sure, but it won’t keep you ahead of the game. Your education will determine your long-term odds, so as we’ve said time & time again, don’t risk real money until you have proof (on a demo) that your model actually has some kind of edge.
We defined Risk Limits here.
Step 3: Position Sizing
In reality, Risk Limits and Position Sizing go hand-in-hand. Most traders just allocate 1% per trade and give no more thought to Position Sizing. However, as we noted here, risking 1% per trade can lead to quite sizeable drawdowns and the risk of ruin (losing all your chips) starts to diverge from zero.
Risk Limits (your maximum loss per day/week/month) is joined at the hip with Position Sizing via trade frequency. Most retail traders have the bad habit of trading too often, going after the money and not considering the incremental risk they are facing as they place all the extra trades.
Quality is hard to come by for any trading model, and a good position sizing plan will require that you find a way to “filter” quality trades. However, we do need a backup plan in order to continue trading even through a string of losses and the most logical way to do this is:
cut the position size by 50% if you lose half of your initial risk for the month.
Let’s imagine having a 3% risk limit for the month, starting at 0.5% and after 3 trades we’re down 1.5%. At this point, we will reduce the trade size to 0.25%.The 7 remaining trades will still allow us additional opportunities, which will hopefully make up for the initial loss.
We spoke in depth about position sizing here.
Step 4: Risk Reward in Practice
Now that we have defined how to “drip-feed” our risk capital into our trading account, and via risk limits and trade frequency have determined a viable position size, we can address the more practical aspect of Risk:Reward. Most traders will have heard that trades should have an ex-ante reward-to-risk ratio of at least 2:1.
Why are large returns important, in principle? They lower the win rate that keeps the trader alive & well.
Minimum Win Rate = 1/(1 + Avg.Reward-to-Risk)
From this formula it’s evident that:
- An average return of 1R requires the win rate to be higher than 50%.
- An average return of 1.5R requires the win rate to be higher than 40%.
- An average return of 2R requires the win rate to be higher than 33%.
- An average return of 3R requires the win rate to be higher than 25%.
Now that would seem quite simple: once you enter your trade, set your target at 2x or 3x your stop loss distance and walk away. Mathematically it makes sense, however in practice there are flaws. The risk reward profile of any single trade is, in fact, variable during the trade.
Take this real-world example: Long NzdJpy on November 14th. In this example, it’s clear that the trader is looking for a move towards the previous resistance area (shaded in green, see the Daily chart below for details). That would offer just over 1R for this trade which, although not great, is viable – together with the fact that NZD had been a strong candidate recently and that we were coming out of the pullback.
So how does one go about establishing the odds further, for this trade? One suggestion might come from the Average True Range Pivots (which we spoke about here). They offer volatility-based expectations for price movement on a daily, weekly and monthly basis.
The logically available space on the day and on the week makes trade management decisions fairly simple. For example, in NZDJPY, it was evident that with a stop loss placed 38 pips from entry, going for an intraday objective around 77.40-45 would have been a poor choice because the trade would produce a return <1R.
Clearly, this trader has a multi-day objective in mind and as such will not be perturbed too much by what price does intraday. With an intraday objective in mind, the trader would likely not move his stop loss during the day, or manage the position during the day unless there was some really evident game changer (a sudden boost through the target zone OR an adverse headline or development that would prompt an early exit).
If the trader wanted to go for a purely intraday target, he would have had to wait for a pullback towards the 77.00 support zone and get aboard with a tighter stop. By entering on the pullback around 77.15 with a stop just below 77.00, the intraday target zone would have offered 2.5:1 odds.
Obviously the trader would also need to have the time availability to manage the trade intraday, because in this case the trader cannot relax and will be required to manage the trade actively.
Another viable entry came on Friday November 16th as price negotiated the 77.00 support once again, consolidated and boosted upwards offering another 3:1 opportunity which had the daily target aligned with the weekly target.
So one takeaway is that by making sure that your trade has space intraday and intraweek, you can stack the odds a little better in your favour. Furthermore, by knowing where price might find resistance or support intraday as well as intraweek, you have logical places to actively manage your position. For example, some traders might prefer to scale out at the intraday target and be ready to re-load on subsequent entries (it’s not really feasible in today’s markets to trail the stop loss intraday unless there’s an evident momentum boost in your favour).
You might ask: how to decide whether to go for an intraday objective or a multiday objective? We covered that here. Remember that:
- the objectives for the trade should be established before entry;
- the objectives for the trade give a logical placement for the stop loss;
- the objectives for the trade dictate the potential reward;
- the market’s gyrations will dictate what happens once the trade is executed.
Here are some rules of thumb for managing trades (which Sam has covered extensively in the Free Advanced Course for Smart Traders):
- Don’t fiddle with the trade unless you really have to!
- Manage your trade at key junctures (support/resistance points, round numbers, ATR levels, ahead of influential news) based on how the market is responding to the level.
- Manage the trade based on the dynamic risk:reward of the trade.
The last consideration to cover is the evolution of the risk:reward profile of your trade while it’s live, based on the market’s gyrations. When the market starts moving towards your intended target, your risk is actually increasing because you have non-consolidated profits to lose, alongside your initial intended stop loss.
What if the market forms a reversal pattern 10 pips away from your target? Do you close the trade? Do you scale out? Do you hold nonetheless? These eventualities need to be factored into the trade management plan.
What I like to do is judge the market’s performance at certain junctures along the way. When the market rewards us with favourable movement, we can shift the risk:reward by trailing the stop loss and thus limiting the tolerable adverse excursion. However, the market doesn’t always oblige and we must be on the lookout for reversal signals. We may also have to scratch trades that start to reverse, after having shown favourable excursion during the day.
There are endless permutations to be explored, and once again there isn’t a right or wrong approach. There’s whatever fits your risk profile!
Over to You
Hopefully now you are equipped with a clear plan to structure and implement your Risk Profile: start with money management, progress with risk limits, then consider position sizing and finally make sure the odds are on your side when taking each single trade.
There will never be a perfect fit or a perfect scenario. However, with this structure you can definitely avoid the vast majority of the pitfalls which cause 90% of retail traders to lose 90% of their capital in 90 days.
About the Author
Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.
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