X is an aggressive trader and he risks 20% of his account on each trade. Y is a conservative trader and she risks 2% of her account on each trade. Both adopt a trading strategy that wins 50% of the time with an average of 1:2 risk to reward. Over the next 10 trades, the outcomes are Lose Lose Lose Lose Lose Lose Win Win Win Win Win.
Here’s the outcome for X :
-20% -20% – 20% – 20% -20%= BLOW UP
Here’s the outcome for Y:
-2% -2% -2% -2% +4% +4% +4% +4% = +8%
Risk Management in Trading could be a deciding factor whether you’re a consistently profitable trader or, losing trader.
Remember, you can have the best trading strategy in the world. But without proper risk management, you won’t be success in trading.
What do we include in Risk Profile?
- What is the level of Risk: Reward ratio will we be working in each trade? Profile
- What is the maximum percentage of our account we are willing to risk on each trade or day or week?
- What is the maximum position size we can use per trade?
Risk Reward Ratio
Risk Defined as The amount a trader is willing to lose on a trade if it hits his or her stop. Calculate risk on trade (size of stop) by measuring the distance between entry and stop loss
The reward is simply defined as the price distance between our entry and our profit point. The trading risk-reward ratio simply determines the potential loss (risk) versus the potential profit (reward) on any given trade.
How to measure the risk-reward ratio?
Risk Reward Ratio(R: R) = Total Risk on each trade / Total Reward on that trade
What’s the maximum percentage of our account we are willing to risk on any one or more trade/s?
- Only risk a small amount of your total account per trade , you want to keep your risk low, perhaps 0.5 to 1 percent
- Only risk a small amount of total account per day. This is called a daily stop. Perhaps set a rule that if you lose 3 or 4 percent of our total account in a given day, you will stop trading for that day
- Only risk a small amount per week. This is called a weekly stop. Perhaps set a rule that if you lose 5 percent of your total account in a given week. you will stop trading for that week
4 Step to determine maximum position size
Step1 = Establish maximum Risk amount per day based on a percentage of account size
Step2 = Divide maximum Risk amount per day with average number of trades per day to calculate risk amount per trade
Step3 = Calculate risk on trade (size of stop) by measuring the distance between entry and stop loss
Step4 = Divide the maximum risk amount per trade by risk on trade to determine the maximum position size
Let’s do it in an example
Maximum Risk percentage per day=2%
Maximum Risk amount per day= Account size* Maximum Risk percentage per day
Number of trades per day =2
Risk amount per trade= Maximum Risk amount per day/ Number of trades per day
Calculate risk on trade (size of stop) =5
Maximum position size= 1000/5=200 shares
The larger the size of your stop loss (risk), the smaller your position size (and vice versa).
Visually, it looks like this:
As long as we can stick to the above risk profile defined, we can enter 10 trades, have 5 looser and only 5 winners but still end up with profit overall.
Active Trade management
Most traders focus too much on their entries as that’s the most hopeful stage of a trade. But the fact is, your exit determines your profit and loss (P&L), not your entry. You can have a good trading entry, but if you manage your trade poorly and exit at the worst possible time, you can still end up with a loss.