Risk & trade management are two important areas of trading that you should have firmly sorted before you start to trade. Whilst they each apply themselves to trading slightly differently – risk management at a macro level and trade management at a more micro level – their objective is essentially the same.
They allow you to put controls in place when trading, to ensure that you do not lose all your money trading in one go. It’s the art of staying in the game!
What is Risk Management?
Risk Management is the process of analyzing your trading, to assess where potential losses might occur and taking action to prevent them. It should form part of your trading plan because if you don’t have a consistent risk management strategy, you will lose money – it’s as simple as that! A first-time trader should always be asking questions such as, “How much of my funds should I risk?” or “What position size per trade should I take?” In order to answer these questions, let’s have a look at two great techniques, taken from the world of ‘game theory’, which are used by professional traders all the time, including me:
Risk of Ruin (RoR):
What are your chances of losing it all?! To calculate this, you use the following Risk of Ruin formula: (1-(W-L))/(1+(W-L))^U W/L = win/loss percentage U = Capital units Let’s look at 2 examples: (Both have a 30% drawdown) Trader A: £50k pot, 10% risked per trade, 60%/40% win/ loss ratio, 3 capital units: = 30% RoR Trader B: £50k pot, 1% risk per trade, 60%/40% win / loss ratio, 30 capital units: = 0.000005214% RoR So you can see what you have to do!! Increase your W/L ratio or reduce your trade size. Obviously you don’t want to lose 100%, so you may set yourself a maximum limit of 30% of your portfolio value. The Risk of Ruin is greatest:
- Up-front when you start
- If you have a small balance
- If you lack essential trading skills
- If you trade for a long period of time without success
Kelly’s Criterion is a money management technique that was developed by John Kelly, a physicist and computer scientist, who worked for AT&T in the 1950’s. For a more detailed look at his theory, read ‘Fortunes Formula’ by William Poundstone (1996). Originally used for betting on horses, it has been adapted over the years to be used by traders and investors to answer questions such as, “How many trades should you have on at once?” and “How much of your portfolio do you want to put at risk, per trade?” It can be used as a guide per strategy and then weighted according to its performance. You need a strategy with a positive expectancy or trading is pointless!! Expectancy = (probability of win * Av. Win) – (Probability of Loss * Av. Loss) Kelly % = W-(1-W)/R R = av. W/L ratio and W = historical win % Example: 60%/40% Win / Loss ratio average risk return = 2:1 =33.3% – so you could use 33.3% of your capital on a particular strategy – so if I’ve got lots of potential trades on I know how many to put on! There are different ways of applying the Kelly approach model.
What Position Size Should I Trade?
You’d be amazed how many people don’t think about this! Often I will ask someone, “You’ve got £10,000 and you think BP shares are going to go up, how much are you going to put on the trade?” I get all sorts of answers! You should only risk 1% to 2% per trade of the portfolio value. This means you can be wrong 50 to 100 times before being wiped out! Statistically having a run that bad is almost impossible and if you did have such a run, may I suggest you should definitely think of doing something else! You should also be guided by your overall trading plan and performance analysis. If you have a strategy that works 90% of the time and returns a 2:1 risk/reward, for example, then obviously scale it up!!!
What is Trade Management?
It’s very easy to get into a trade, but you can just as easily destroy a good strategy with poor trade management. Trade management is the process of managing your trade to successful financial fruition, by ensuring maximum profit and minimum risk. Your trade entry and exit should be planned around a pre-defined strategy. Your pre-trade details, results and thoughts should all be recorded. Traders often get into their positions through fundamental analysis and then use technical analysis to optimise both their entry and exit. Some traders rely purely on technical analysis for the whole thing. As an example: I think gold is going up, but globally gold looks bearish at the moment. I wait until the technical indicators show me a good long to enter, rather than just blindly entering the trade. Before entering the trade, I also plan my exit strategy by setting objectives; these all come from the trading and strategy plans I already have in place.
I was always taught to trade with Stops – period! They are a great trade management tool for so many reasons. There are numerous ‘stop’ strategies that you could employ and many are personal to the trader, the markets you trade and current market conditions. So what, exactly, are stops? Stops are a trade management tool that let you ‘stop’ a loss or ‘stop’ a profit (also known as a LIMIT order). They are simply orders that become live when they hit a pre-defined target set by you. They stop you losing the shirt off of your back! With these in place, if the market moves against you, you will be taken out of your trade at a pre-defined safe level. They limit your losses. You need to master Stops to become successful in trading and they are the key to your longer term profit making potential. They should be used in conjunction with position sizing. Types of stop orders you could use are:
- Technical: Support and resistance: MAV’s / Fibonacci/ trendlines / price /patterns
- Oscillators: ATR (Price Volatility)
- Trailing: if trending e.g. ATR / SAR parabolic
- Tight: if intraday trading / price ranging e.g. Oscillators
- Longer term trader: wider stops e.g. support and resistance
One of the key advantages of using stops, is that they can be used as a way of freeing up capital. When spread betting, I like to use guaranteed stops and leave in limit orders. The golden rule when using stops is, don’t ever adjust your stop, pushing it wider, just because the trade is going wrong – this is fatal!
Risk & Trade Management: A Life Saver During Swiss (CHF) Madness!
The importance of risk and trade management was no better highlighted than during the recent Swiss currency madness. At 12.15pm on January 15th, The SNB announced a surprise ending to the cap it had on the Euro and this sent the markets into turmoil. There were some technical signs that a down move was anticipated, but not to this magnitude! The move was so big I can’t even get a decent looking chart for you! Here it is anyway on the 30 min chart:
An unbelievable day in the markets, where even professional brokers were wiped out. Luckily, I was the right side of that move and had sound risk and trade controls in place, which stopped me from losing a heck load of money. So, risk & trade management may not be the most exciting part of trading, but they are utterly essential if you don’t want to lose all your money trading in one go. A little bit of forethought and self-control goes a long way to ensuring that you stay in the game long enough to be successful.