Risk management: Your Brief Guide For Survival

“Magical thinking”.

Trading is associated with financial risk. It is so obvious, that risk disclaimers rarely attract any attention from traders. Many people would like to think positively and not picture possible failure. It’s strange psychological phenomenon related to trading. For any other type business, people tend to be more rational, think strategically, don’t chase for quick results e t.c.. When it comes to trading, the same people turn on “magical thinking”. For some reason they think that keeping positive mind is enough.

We admit that trading is a “mind game”. Yet, successful mindset would not save you from failure if you don’t build winning math. That’s what we are going to talk about in this article.

Nobody wants to lose money. But you will incur losses from time to time in trading, that’s inevitable. Professional traders know that and take their losses under strict control.

“Winning math”.

Before you put real money on the line, you have to develop sound money management plan. Absence of one is the most common reason for failure among traders. No brilliant analytical skills would help if you don’t have money management plan in the first place. We call it “winning math”. If you back your trading with the “winning math”, you open a path to other trading edges: analytical and chart reading skills, pattern recognition, reading “psychological” patterns e t.c.

So, don’t rush to send buy or sell order, give yourself time to read this article.

All numbers in this article are hypothetical and provided as examples. Don’t treat them as a recommendations.

What should money management plan consist of?

First, and foremost, you should know percentage of capital, which you can afford to lose in a single trade. Then, you should have loss limit for the day - it is especially important if you are a day trader. Loss limit for the week (or month) is not mandatory, but highly recommended. And finally, you should have ultimate loss limit - you are not expected to resume trading in case it is achieved, at least for some period of time.

Beyond all that, you can have plan for withdrawing/depositing funds. For example, you may decide to re-invest or save some of the profit.

Ultimate Loss limit

Start your money management plan with defining ultimate loss limit. Is losing 50% of your account affordable to you? What about 30%, 20%?

Some traders say that they see no problem in risking entire trading account, yet you should remember, that if you blow up your account today, you don’t have opportunity to trade tomorrow.

Core principle of professional traders is to stay in the game.

Let’s imagine, you defined ultimate loss limit as 50%. What does it exactly mean? First of all, you should stop your trading activity after reaching this level. We hope, that it won’t happen to you, but it’s like a emergency brake - you have to have one.

Does it mean that you should quit your trading career after losing 50% of funds? Not at all. You will just have to take a break, analyze your performance, work on mistakes.

And don’t think it is easy. Every cell of your body might scream, asking to continue trading. Are you capable to overcome it and stop trading, thus saving the rest of your account from ruin?

Monthly/weekly loss limit

After you defined your ultimate loss limit, the next step is to split it to several pieces. You don’t want to reach your ultimate loss limit quickly.

You might simply divide it to 3 parts (16% each if your ultimate loss limit is equal to 50%), or define maximum loss for certain time period.

For example, if you trade actively making several trades for a day, it’s recommended to have weekly loss limit. If you started your week with a losing streak, and quickly lost 16% of your account, it’s time to stop your trading until the next week.

If you trade less actively and make several trades for a week, it may be better to have monthly loss limit. Imagine that you have 2 weeks of poor trading performance, which take away 16% from your account. Stop your trading for the rest of the month.

Daily loss limit

If you are a day trader, you are recommended to have daily loss limit. In most trading firms, traders have pre-determined daily loss limit, which is, being achieved, makes you stop your trading until the next day.

Having daily loss limit might not be suitable for all trading styles. For example, for swing traders, who work with a tight stop within a day, but hold it for several days, it might not be a good solution. If your trading performance is polarized, i.e. you earn most of your profit on a few good trades, it’s worse to miss a trade rather than to capture another stop loss.

It you nevertheless decide to have daily loss limit, you can divide your weekly loss limit by 3. In case, your weekly loss limit is 16 % (for ultimate loss limit of 50%), your daily loss limit can equal to 5%.

Risk per trade

And last, but not least, is your risk per trade. How much risk measured in money, can you withstand in a single trade? Usually, risk per trade is measured in percent of a capital. For example, if you capital is $5000 and your risk per trade is 1%, you are willing to lose $50 in a trade.

To fit your trading to risk parameters, you have to know where your stop loss should be located in terms of pips. If your account size is $5000, your stop loss is 50 pips, and your risk per trade is $50 (1%), cost of a pip would be equal to 1$, which corresponds to lot size of 0.1. Use special trading calculator to correctly calculate your lot size.

For active trading styles

Active trading styles usually have modest edge and not very big profit factor (sum of profits divided by sum of losses)  - if you have around 55% of winning trades, you need to generate more trading volume (say, make more trades) to keep above water. So, you don’t want to wiped out from trading very quickly. That’s why, if you make many trades per day, taking more than 1% for a single trade is not recommended.

For swing trading

For swing trading, when you do 2-3 trades a week, your risk per trade may be equal to 2% of your account. The more selectively you trade, the better profit factor you may achieve, and the less your result depends on amount of trades executed.

In other words - losing streak is not a norm, when you are trading selectively (not actively), unlike for active day trading, when your equity may soar and decline several times a day. So, if you cut your losses faster, it would reasonable for longer term trading.

And finally, for swing trading, your stop loss won’t be as small as 5-10 pips (like in active day trading), you will have to give a space of 50-70 pips for the market. Probability of getting 50 pips stop quickly is less that getting 5-10 pips stop, therefore risk per trade may be slightly greater in this case. (2% instead of 1%)

For position trading

For position trading (2-3 trades a month), risk per trade can be increased to 3%. It’s not recommended to exceed this value - sometimes, you will have losing streaks and still you will need to stay in the game.

Most professional traders try not to take too much risk for a single trade, because if you occasionally find good trade in another market, you would like to have free buying power to realize that trade. If your risk for single trade is too large, you may not have opportunity to open additional trade.

How many positions could you have simultaneously?

If you trade several markets at the same time, you might decide to have several positions opened simultaneously. Then, simply, summarize all the risks and see whether this summarized risk doesn’t exceed your daily loss limit (weekly/monthly loss limit if you don’t have daily one).

If you open 2 trades with correlated instruments, it doubles your risk. For example, if you go long trade for EURUSD and short trade for USDCHF, you have two correlated positions since they would, supposedly, move in similar manner. If you open positions, which compensate each other, like long EURUSD and short EURGBP, probability of being stopped out from each position is smaller.

Take this into consideration.

Deposit/withdrawal plan

Managing losses is the most important part of your trading process, yet it’s better if you also have a plan for managing your gains.

If you generated profit for the month, you have to decide beforehand - how much money should you leave on your account, and how much would you withdraw for your personal expenses.

There is a simply 50/50 rule, which is popular among professional trades. They leave 50% of the profits on the account and take (withdraw) 50% for living expenses. Also, you may keep 10% of the profit for financial reserve.

Bottom line:

Before you start trading real money, consider creating and writing down your money management plan.

Start with Ultimate loss limit. Then, define weekly/monthly, and daily loss limit. If you are swing or position trader, holding position for several days, you might not have daily loss limit. For day traders, it’s recommended to have one.

Define your risk per trade upon your trading style. The more actively you trade, the less risk per trade is recommended to have. Selective trading with wider stops gives you opportunity to slightly increase your risk for a single trade.

Finally, develop your withdrawal/deposit plan. Managing losses is important part of a process, but it’s good if you have prescribed plan for managing profits. You may define your own plan or use popular 50/50 plan (taking 50% of the profits for living expenses).

 

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