What is Risk & Money Management?
Failure to take on board the concepts outlined in this Sticky could be ruinous. It holds the key to success or
failure of every trader. The reason that it’s so important is because trading leveraged products such as spread betting carries the risk of a margin call (i.e. funds on deposit with your broker are not enough to cover a loss). In this event, you could end up owing your broker more than your initial deposit. In extreme cases, this could result in bankruptcy and loss of your house or other assets.
If you’re trading without a thoroughly tested methodology in place (see the
Trading Plan Template), then, even without a margin call, your capital is quite likely to drain away - albeit more slowly. Please note that while a trading plan is no guarantee of success, trading without one will impact the probability of success massively. Needless to say - not in a good way! If you aren't clear about any aspect of risk and money management, or require help with this topic, just post your questions or concerns to this thread. Okay, let’s get started . . .
This Essentials Sticky will use a ‘top down’ approach to look at risk and money management, starting with a simple definition of each. Inevitably, there will be aspects of your trading life that are not covered by this Sticky. Therefore, please note that it is not a comprehensive ‘cookie cutter’ type solution that absolves you of all responsibility for the risks you take. On the contrary, it’s designed to get you to examine your own trading routine, and then implement bespoke risk strategies that reflect your attitude to risk whilst, hopefully, meeting your trading objectives.
So, what exactly is risk and money management? Risk management focuses on the steps necessary to minimise losses, while money management focuses on the steps necessary to maximise profits. The former is achieved by conducting a risk assessment of anything and everything which could affect your P&L and result in loss. Its broad focus is on what you can do
before you enter a trade. If you want to day trade from an iPhone mid way along a high wire in 70mph winds and put every penny you’re worth on every trade – that’s absolutely fine. But, before stepping onto the wire, consider first what could happen if you drop your phone mid trade (but before you have a stop order in place), the wind gusts to 100mph and you lose your footing. It’s not for T2W or this Sticky to tell you not to do it. Its purpose is to get you to consider the effects of the risks you take and the impact on your trading account (or your life in this case) in the event that they all conspire against you. As with most things in trading, there are very few absolutes, only what’s right or wrong for you.
Money management focuses on correct position sizing, monitoring all open positions and adapting to changing market conditions. Its broad focus is on what you can do
after you enter a trade. The two are summarised by that giant of trading axioms: ‘cut your losses short (i.e. risk management) and let your profits run’ (i.e. money management). The main focus of this Sticky will be on risk management because the primary objective of all traders is capital preservation. You can’t make money with money you’ve lost. In the words of Warren Buffett: “Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.”
What’s Your Risk Tolerance?
This may seem like an odd question, but it’s a good starting point to ensure that your feelings about risk are compatible with your trading style. Risks that appear to be audacious and foolhardy to one trader may be considered safe and conservative by the next. David S. Nassar, in his book
How to Get Started in Electronic Day Trading has this to offer on the subject:
“Think of the stock market as a nuclear reactor – the more you are exposed to radiation the greater the chance of getting burned. Market risk is measured by the amount of time you are in the market. It could be seconds, minutes, hours, days or weeks. The longer you are in the market the greater the chance something will go wrong. Therefore, the trading style that keeps you in the longest can also be the most risky”. Many traders will totally disagree with this and feel much happier and sleep better at night by holding medium to long-term positions. For them, day trading volatile NASDAQ stocks or the ES (the e-mini S&P 500 futures contract, referred to by some folk as ‘crack for traders’) carries far too much risk.
Next, we’ll look briefly at specific risk areas and how you might minimise the risks associated with each one. As mentioned in the opening paragraph, please note that this is not a comprehensive list. There will be areas of risk that are unique to you and your personal circumstances. For example, if you’re a cat owner, beware of leaving your trading desk if the cat can get near it. Cuddly furry creatures and instant ‘one-click’ order execution is, potentially, a painfully expensive combination! When it comes to trading, whatever is conceivable and even faintly feasible –
will happen sooner or later. Be prepared!
Market Risk
Each market has specific risks associated with it that you must understand and factor in to your methodology. News is an obvious example. If you’re an index futures day trader and you enter a trade ahead of a Non-Farm Payrolls announcement (NFP) – you’re likely to get your fingers burnt. Similarly, if you’re an equities swing trader, you could easily come unstuck by opening a position just ahead of an earnings announcement. Trading around major news announcements that impact your market is highly risky unless you know exactly what you’re doing.
You cannot eradicate risk; it’s an inherent part of trading. All you can do is to choose a market and trading style where the risks are acceptable to you and you have a clearly defined approach for managing them. For example, if you position trade equities (i.e. hold trades for weeks or months at a time), there is the possibility that the share price of a company could collapse to zero. That’s not good news if you’re long the market! However, the same thing can’t happen to traders of major Forex pairs. At least, if it did, financial Armageddon would be likely to ensue and the equities markets would probably collapse too. Forex traders rightly argue that theirs is the largest and most liquid market in the world and, unlike some stocks; it’s relatively easy to enter and exit trades at the price you want. Conversely, some equities traders steer clear of Forex because it’s an ‘over the counter’ (OTC) market, meaning there’s no central exchange and, therefore, it’s largely unregulated. By contrast, equities are highly regulated and highly transparent, especially in the U.S. Home based retail equities traders can trade on a level playing field with institutional traders; a boast that few retail forex traders can make. It’s swings and roundabouts; there are inherent risks associated with all markets; you must decide which one is right for you.
Sector Risk
Anyone who saw the fictional television drama
The Man Who Broke Britain (09/12/2004 on BBC2) will recall what happened when a bank that traded oil futures had a massive un-hedged long position. Its traders – who were the toast of the city - did well until terrorists blew up the world’s largest oil refinery. Oops! No fat cat bonuses for them and, ultimately, a resulting banking crisis on a scale of the one that would unfold for real three years later in 2007, sparked by the U.S. sub-prime mortgage fiasco. One way to control sector risk is to limit the number of your positions in any one sector.
Broker and Hardware Risk
Suppose your trading platform goes down and you can’t close your positions, how will you handle this scenario? Similarly, what will you do if you need to take action when (not if!) your PC crashes or there’s a power outage? You need to plan for all these eventualities in advance. When it happens – and it will - you don’t want to be riffling through your in-tray, looking for a letter or a statement containing your broker’s phone number. It should be on speed dial on your mobile. And where’s your mobile? Why, it’s next to you on your desk and fully charged of course!
Strategy Risk
The markets are constantly changing and a strategy that was profitable last month / year may not be profitable next month / year. As a long stop, prepare for the ultimate risk – one that probably will happen sooner or later. Namely, that your once brilliant and hugely profitable trading strategy no longer works! Control this by measuring the largest percentage drawdown on each strategy employed. Multiply this by a factor of 1.5 to 2, and if the drawdown ever exceeds this figure, STOP trading the strategy immediately!
SPECIFIC RISK MANAGEMENT
Hopefully, you’ve taken on board that before you try and assess the specific risks associated with any one trade; there are a whole bunch of general risks that you would be wise to consider. What they all are and how you deal with them will be individual to you and your personal circumstances.
Do You Have a Positive Expectancy?
Risk management focuses on the steps required to minimise losses, while money management focuses on the steps required to maximise gains. Central to both these objectives are two simple ratios which, between them, enable traders to create a
Positive Expectancy. A positive expectancy is a good example of one of the few absolutes in trading. If you don’t know what it is or how to get it, your chances of success as a trader are greatly reduced. If you do well, it’ll be the result of luck, akin to winning the lottery. All traders who do consistently well over the medium to long term have a methodology that produces a positive expectancy.
The two key ratios are:
A) The
Success Ratio. Out of any given sample, what is the total number of winning trades relative to the total number of losing trades? This is called the success ratio or win:loss ratio.
B) The
Profit Ratio. This is the average £’s won on winning trades, relative to the average £’s lost on losing trades. This is called the profit ratio and is sometimes referred to as the ‘Sharpe Ratio’, although this is technically incorrect.
Once you know your Success and Profit ratios, you can calculate the expectancy of every trade you take. It’s important to remember that a positive figure indicates that you’ll be profitable over time, not that each and every trade will be profitable. Casinos and bookmakers have a positive expectancy; yet each pays out millions every week to gamblers who get lucky. The punters win occasionally, but they have an overall negative expectancy which ensures that they lose in the long run.
Consider a fair coin toss. The success ratio of flipping heads or tails is known to be 50/50 or 1:1. Now, for the sake of argument, let’s suppose that heads wins +£10.00 and tails loses -£5.00. In other words, the profit ratio is 2:1, as the winning coin (heads) wins twice as much as the losing coin (tails) loses. Any one coin toss could be a loser and you could easily have 3, 4, 5 or more losers in a row. However, over time and with a large enough sample, you know you’ll end up with around 50% winners and 50% losers. Suppose the sample is 100 coin tosses. 50 winners at +£10.00 each = +£500.00 and 50 losers at -£5.00 each = -£250.00. Therefore, your profit is +£250.00, giving you a positive expectancy of +£2.50 for each and every one hundred times the coin was flipped.
There are a number of important things to note about the Success and Profit Ratios. The first is that the former can be very poor and be compensated for by the latter. In other words, some of the most successful traders only ‘win’ about 30%-40% of the time, but their profitable trades are extremely profitable compared to the losses on their losing trades which, although greater in number, are small. However, such a methodology is very tough psychologically for retail traders putting their own money at risk, because they may endure a long streak of losing trades. To stick rigidly to your methodology in these circumstances, whilst not wavering from the belief that all will come good in the end, is not for the faint hearted. What is more common among T2W members is the exact opposite. Many of them enjoy a high success ratio upwards of 65%. However, they often struggle to minimise their losses and the profits on the winning trades are often small. To illustrate this with an extreme example - for every 100 trades, there’s no point winning £1.00 on 99 of them, only to then lose £100.00 (or more) on the 100th one!
The other thing to note about the two ratios is consistency. Good traders will monitor both ratios on an ongoing basis and, if their methodology is finely tuned, the ratios won’t vary greatly from one week or month to the next. This is what you must strive to achieve. If the two ratios are darting about all over the place, such that you have a positive expectancy one week and a negative one the next – it‘s likely to mean one thing: your methodology is flawed. Either that or you’re not executing your trade plan consistently. The latter tends to boil down to discipline issues, while the former means there’s a bug in the system which needs to be ironed out. If the ratios remain constant for a long period and then start to become unstable, this suggests a change in market dynamics. Besides a drop off in your equity curve, this is the other alarm bell that will sound to indicate that your once profitable strategy no longer works in the current market conditions.
What is Your Risk per Trade?
Even with a positive expectancy, if you risk too much of your account on any one trade you can ‘blow up’ (traders jargon for losing a large percentage - or all - of your account). Be prepared for the worst. In the event of another terrorist attack like 9/11 or the ‘Flash Crash’ of May 2010, having too much of your equity committed to the market could result in catastrophic loss. Many traders will not risk more than 1% on any one trade, with a maximum exposure on all open positions of 5% in total. In other words, if disaster strikes and all your open positions are stopped out at a loss, the drawdown on your account would not exceed 5%. Nasty, but not catastrophic. Keep in mind that in both these examples, markets moved so fast and so far that not all stop loss orders were triggered. Telephone exchanges and ISPs froze, preventing some traders from closing their positions as the markets moved against them. ‘Black Swan’ events as they are known such as these are tricky to plan for; nonetheless, you would be wise to include them in to your risk management planning.
Generally speaking, the smaller the amount you risk per trade - the better. Better because it’s psychologically much easier to handle. If you have a £1,000 account and you risk 1%, i.e. £10.00, hopefully you won’t lose much sleep if the trade doesn’t pan out. But, if you risk and lose 5%, 10% or more on one trade, will you have any fingernails left, will there be large dark bags under your eyes and will you be consumed with doubt and anxiety when you next put on a trade? There are no right or wrong answers, no hard and fast absolutes, only what’s right and wrong for you.
Stop Loss Orders
Unless you are a seasoned professional trader, make sure you place an actual pending stop loss order in the market,
not just a mental stop! This will ensure that all losses are cut short. Also, if at all possible, make sure your stop is market controlled and not a fixed percentage of your equity. E.g., if you trade pullbacks, and your strategy dictates that you place your stop loss just below the low of the pullback, then that is where it should go. Vary the number of contracts / shares to ensure that you remain within your risk per trade parameters. Admittedly, this can be tricky to achieve on small accounts.
Know when to Stop Trading
Knowing when to stop trading is both good discipline and good risk management. Many blow ups have occurred because traders have indulged in ‘revenge trading’ - trying to recoup losses or, conversely, getting over confident after a winning streak. Either way, having a ‘dead man’s handle’ type mechanism in place to prevent chasing losses on losing days and to prevent greed from rearing its ugly head on winning days, is an important element of your risk strategy. Try to ensure every trading day/week ends in one of three ways:
1. On a winning day/week, have a very simple rule for stopping trading once you have reached your target. Or, alternatively, if you carry on trading, have a mechanism in place to protect your gains to ensure you don’t over trade and give back your profits (and more) to the market.
2. On a losing day/week, have a predefined stop and cease trading as soon as it is hit. There are two common approaches to dealing with this problem. The first is to switch to a demo account and paper trade. The second is to have a second account – typically with a spread betting broker - that’s funded to the tune of a few hundred pounds only. You can then continue to trade ‘live’, but with very small size (i.e. pence per point rather than pounds per point).
3. Some days there are not any trading opportunities to be had, so you do not trade at all. When you get good at spotting them, take the day off and play golf or whatever floats your boat. Trading a market you have no business to be in because the opportunities simply aren’t there has lead to the downfall of many T2W members. Arguably, sitting on your hands or turning off your screens is one of the hardest things for a trader to do. However, learn to do it you must, otherwise your positive expectancy could turn negative very quickly.
MONEY MANAGEMENT
So far, we’ve looked at risk management and some the steps you can take to avoid loss. Now we’ll address a few of the measures you can take to help maximise any gains.
Stop Losses (Again)
As stated in the risk management section, utilizing stop loss orders is vital to your survival as a trader. However, they can be very tricky things to use effectively. If they are set too tight to your entry point, you run the risk of being stopped out more often than if they are placed further away. That’s going to have an adverse impact on your Success ratio. If you place them too far away from your entry point, they’ll be triggered less often, but it could have a negative impact on your Profit ratio. Many traders, especially newbies, focus exclusively on market direction, trade set ups and entry triggers. Scant regard is paid to the position of a stop loss. Unfortunately, it’s possible to be very proficient at all three of these and yet, frustratingly, fail to make consistent profits. The reason being, often as not, that the stop loss is set too close or too far away from the entry point. To get the balance right, a key factor to consider is the volatility of the instrument you’re trading. This not only varies from one market to the next, but from one instrument to the next. Moreover, even if you just trade one instrument – the ES for example – there can be wild swings in its volatility, especially intra-day. (By way of an example, look at a 1 minute to 5 minute chart of any U.S. stock index at the time of a NFP announcement or a speech by Ben Bernanke, Chairman of the Federal Reserve Bank.) Volatile instruments require extra ‘wiggle room’, whereas, smooth and steady instruments enable you to set much tighter stops.
Besides volatility, there are technical factors that you might want to consider when deciding where to place your stop. A common tactic is to place stops just above swing highs and below swing lows, or just above or below a trading range. However, some traders feel this is too obvious and that the high frequency traders (HFTs) algorithms will hit these areas to pocket some easy money. Instead, they prefer to use a mathematical stop or one based on a multiple of an indicator such as the Average True Range (ATR). And then there are those traders who prefer not to use stops at all but, instead, trade pairs or hedge their position with another highly correlated instrument. This is a more sophisticated technique and not one that’s well suited to new traders just starting out.
Position Size
The size of your position should never exceed the parameters specified in your risk management rules. That said, there are still many options available. Some strategies might have a high probability of success (e.g. trend continuation strategies) enabling you to adopt a more aggressive position size at entry. Other strategies might have a lower probability of success (e.g. reversal or counter trend strategies) and your risk management criterion dictates a more conservative position size at entry. However, once the trade and the new trend are established, it may be advantageous to add to the position at specific continuation signals. Potentially, this allows for a large position size to accumulate, whilst all the time maintaining a low exposure to risk.
Most traders prefer to decide where to place their stop first and let this dictate the size of their position. The key point to remember is that in the event the stop is triggered, you don’t want to lose more than a fixed percentage of your account. For a greater exploration of stops and position size, check out his FAQ:
Realistically, How much Money can I Expect to Make?
Moving Your Stop Loss
If you’re a new trader, there is a golden rule you’d do well to adhere to: only ever move your stop loss one way –
towards your point of entry. Never move it down (if you’re long the market) or up (if you’re short the market). If you’ve worked out the position properly to begin with, then it ought to be in the optimum place to ensure your trade has the maximum chance of success. However, it goes without saying that the market is a fluid and dynamic environment that changes constantly. If the premise that validated the trade at the time of entry changes, then get out before your stop loss is triggered. An obvious example would be a shock news announcement, and a market that had been steadily trending upwards suddenly starts tanking. This is active money management, responding to what is actually happening in the market.
Working out where to place your stop loss when you initiate a trade is only half the battle. With trades that go against you, you’ve basically got two options: either wait for your stop to be hit or foreclose the trade for a smaller loss. Trades that go in the ‘right’ direction and generate a paper profit pose a bigger problem. Do you move your stop to break even at some point, leave it where it is or trail it behind price? Or, you could close half the position when an initial profit target is reached and the leave the stop in the original position, remembering to adjust its size if your platform doesn’t do so automatically. There are a myriad of different options and working out which is best for you will take time. Many traders allow their psychology to determine how they manage their positions. Some traders will always take a partial profit early on as they can’t bear to see a winning trade reverse back down to break even or, worse still, into negative territory. In the next post, there will be some links to give you some ideas to explore.
Drawdowns and Profits
Your trading capital must be money that you can afford to lose and be set aside from everyday expenses. If you lost the lot, it should make no difference to your standard of living. Clearly define in your trading plan the extent to which you will credit additional funds to your account in the event of large drawdowns and debit the account when it starts to burst at the seams with huge profits!
A common feature amongst many T2W members that’s been well documented over the years is the problem associated with trading different sized accounts. Small accounts tend to have fewer problems associated with them than large ones. Defining what’s small, medium or large will vary from one trader to the next, based on their trading objectives and financial status. As a rough guide, let’s say small equates to an account of less than a £1,000. It’s not uncommon for traders to build an account from say, £500 to £1,000 in 6 months or less. They get excited and think that having made a 100% gain in 6 months they can then compound it to a gain of 400% over the year. Then they work out their gains with a £5k or £20k account. Soon after that, the classic line from Del Boy in Only Fools & Horses’ is heard: ‘this time next year Rodney, we’ll be millionaires!’ It never happens; it almost always breaks down. Growing a small account into a large one isn’t easy and traders who double their account size every 6 months – or even every year - are as rare as hen’s teeth. To achieve such a feat will necessitate taking far larger risks than the relatively modest ones outlined in this Sticky.
Conclusion
Develop and maintain a positive expectancy. Look for small, regular gains; you’re not aiming to make spectacular lottery sized wins in double quick time. Or, if you are, understand that what you’re doing dramatically increases the likelihood of you blowing up and losing all your money. Worse than that, potentially, you could lose more than just the funds on deposit with your broker. The cardinal rule regarding risk in trading is to understand and acknowledge what the risk is. That way, whatever the outcome of a trade – it won’t come as a nasty shock. Hopefully, by following the principles outlined in this Sticky, the nasty shocks will be minimal and your profits will start to build. As that happens, decide whether to risk more per trade, bank your profits or diversify into other trading strategies or investments.
The bottom line about risk is to follow the lead of the professionals and trade like they do. Inexperienced retail traders are seduced by the scam ads littered all over the internet promising great riches for little or no work. Right from the get go they’re focused on how much money they’re going to make. Professionals do the exact opposite. They focus on how much money they stand to lose and what measures they can take to ensure any losses are kept to an absolute minimum. Follow their lead: trade like a pro by protecting and preserving your capital at all times.
