Sensible Risk Management

Sensible Risk Management

The Foundation of your Trading Business

One of the most fundamental steps to regaining and keeping control over your trading performance is to protect your account balance. You must be relentless and boringly repetitive with implementing your money management rules.

Without obeying these rules meticulously trading will always be an uphill battle and your account will always be prone to the sudden event that decimates your account and wipes out all the hard-earned gains you have made.

Beginner traders often cannot see how they will make their fortunes without risking a lot, while intermediate traders often think their experience and intuition is a form of money management and protection from disaster, but this thinking is flawed and is, in fact, damaging to their progress.

Trading success does not come from risking a lot: it comes from controlling your risk and using that as a solid base on which to build your trading business.

With that in mind we will show you some solid rules you can start using immediately that will stop the rot, give your account protection and give you this solid base to build upon and grow your account in the right direction, and faster. Here are the key account-protecting questions to ask yourself:

See the example at the end of this blog and the discussion on how TradesByTheBook can hep you with good risk and money management.

The purpose of money management is to tell you how many units (shares or contracts) you are going to put on, given the size or your account.

How much should I risk on a single trade?

If you accept that (1) you do not have a crystal ball and (2) you do not know what can happen next and (3) absolutely anything can happen in the next few minutes (think terrorist attack, Swiss bank removing cap of their currency vs. Euro, China devaluing Yuan, natural disasters), then you will immediately appreciate the need to always, always, always have a stop-level defined for every trade you make. Otherwise you are simply gambling that no major surprise move against your trade will happen.

The amount of money that you risk on any one trade should be a suitably small percentage of your account that, if you lose it, it will not significantly damage your account.

There are many schools of thought about how much you should risk on a single trade but a commonly quoted number for stock-traders is 2% of your trading account. But for many professional traders, 2% seems uncomfortably high and a very large amount to risk and they will often only risk 1% or less. Losing 2% of their account means something has gone drastically wrong.

In fact, putting a single number on a trade risk does not take into account many other factors, such as:

- How experienced a trader are you?
- How comfortable are you with the money-loss this % represents? You must be comfortable with this value and sleep well at night without stressing about the loss.
- How confident are you about the trade? Surely if you are very confident (e.g. using a repetitive proven strategy and all indicators and environment factors have lined up nicely) then it seems only sensible to risk a little more.

So, with all that in mind, here is one example of you could define your trade risk in terms of your confidence, your experience and your comfort levels with the money involved, while keeping the risk below the often-quoted examples. (There are endless ways to manage risk - this is just an example of how to keep your risk low and controlled)

This gives beginner traderss a restriction to only place small or standard trades while they are learning, while allowing traders with more experience the options to assign risk according to their confidence levels in the current trade.
(Of course these numbers are an example – they can be adjusted according to the personal risk tolerance of the trader)

Increase your bets when you are confident and scale down your positions when you don’t have conviction.

How can I limit the drawdown of my account in a given month?

So, limiting the risk on an individual trade protects our accounts from the trade moving against us. That’s all very well, but that does not prevent us from placing 100 trades in quick succession and losing money on all of them. As unlucky as that may sound it is not impossible.

Trading too often, called Over-Trading, is another sure way to destroy your account. We need a way to warn ourselves when there have been too many nibbles at our account – when the losses from over-trading are adding up to significant account destruction.

Many traders use a rule which prevents over-trading. If your account loses value in any month by a set amount, then the trader should stop trading and study what is going wrong for the remainder of the month. Dr. Alexander Elder in his book “Trading for a Living” (see Recommended Reading) advises a “6% rule” for limiting the maximum losses in a given month to 6% of your trading account.

So, after comparing the value of your account currently to the value at the start of the month, if the value has dropped to 94% of the starting monthly value, you must stop trading for the rest of the month.

This achieves a number of goals Stops the small nibbles at your account due to over-trading Forces the trader to stop, and study his/her strategies and the market Slows the trader down from the reactionary quick-trades

How can I control the money that is currently at risk from open trades at any one time?

Closely related to the single-trade risk rule and the monthly-trade-risk rule above is putting a limit on the maximum allowable risk to be open on your account at any one time.

If you have 3 trades open and each trade’s stop is 2% of your account then the maximum open risk is 6% => if all trades move against you, you will incur a 6% loss on your account. If you are using the 6% monthly rule then this is your entire risk-budget for the month. This could all be lost on day 1 of the new month and you would have to sit out the remainder of the month (according to the monthly rule). That does not sound like much fun and could get frustrating quickly as traders start breaking their rules and over-trading.

What about limiting open risk to, say, 3% of your account. If you have 3 trades in play at 1% risk each, then you must wait until a trade is exited or a stop is moved to reduce your exposure before placing the next trade. If a trader is using a 0.75% trade-risk he/she could have 4 trades open and still only risk 3% of the account.

Once again, this rule is designed to slow the trader down to pay attention to the risk he/she is applying to each trade and get full control of the risk.

Summary - Sensible Risk Management

In short, here is a summary of how you could manage your risk for a new trade:

1. Am I allowed to place a new trade? Yes, I am but only if:
1. I have not lost 6% of my account this month
2. My total risk of my current open trades does not exceed 3%
2. Decide on your confidence level for the proposed trade
3. Ensure that placing a new trade does not break rules 1a or 1b if you place the new trade, otherwise you must lower your risk
4. Identify the entry-level and the stop-level of the trade
5. Calculate the amount of shares you are allowed buy (or sell short)
6. Place the order for the new trade with your broker and enter the stop-level protection at the same time (to avoid any difficult decision-making later)

Example

On the 26th June 2015, AAPL closed up for the day and above a Moving Average. I decide to place an order to buy it the next day once it takes out the high of the day of 91.05. The 14-day Average True Range (ATR) is at 1.3907 so I place my stop at 2xATR away which is 2.7814 below my entry of 91.06. @ 88.28.

Therefore the amount of shares I can buy @ 91.06, with a 88.28 stop, is 134 shares *

I enter my order into my trading platform with entry level and stop level at the same time.

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