When it comes to trading, especially with new traders, risk is often an after thought.
This is a dire mistake.
In reality, risk should be your number one priority. It can help limit drawdowns in both length and severity, and most importantly, keep you from blowing up your account.
Famous investor George Soros said, “It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”
Letting losing trades get out of hand can cripple your pnl and, in worst case scenarios, wipe out your account completely.
In this post we’ll look at:
- Understanding risk “R” at a deeper level
- How much should you be risking?
- Adjusting risk as a trade moves in your favor
- Best practices for adjusting risk during a drawdown
Really Understanding Risk
Risk in its simplest form is how much we can lose on a given trade. You cannot trade without risk, it’s a part of the business same as with playing poker or betting on the ponies.
But it is the one thing you have the most control over in your trading.
Creating a risk management plan is how we protect ourselves.
If you don’t have a strong risk management strategy that you implement religiously then there is a high likelihood you won’t be trading for long. That’s the hard truth.
Learn to manage your loses and you’ll be in a much better position than most traders.
Prioritizing “R”
So what does “R” really mean?
Say we buy a stock at $100 per share, and we place a stop at $99, we are risking $1 on the trade, which means our “R” is $1. Say you sell that stock at $103, you made 3R on that trade or 3 times your risk amount.
Thinking in terms of R can help eliminate the mental blocks when it comes to dollar amounts. You’ve probably noticed this in your trading when watching your pnl, it weighs on your decision making and clouds your judgement.
Quick side note – stop looking at your pnl when trading. Hide it behind another window. It won’t do you any good having it out, staring at you while you’re trying to make decisions.
Using R as a way of thinking about risk, can also help you measure your trades in a more meaningful manner. Saying I made 2R on a trade instead of saying I made $1,000 on a trade tells me that you made twice as much as you risked and was a solid trade.
Saying you made $1,000 doesn’t really mean anything. What if you were risking $5k and made $1k or you were risking $100 and made $1k. Those have very different outcomes in terms of R. The first trade you made 1/5th R while on the other trade you made 10R. Huge differences in terms of profitability of the trade.
How Much Should You Risk?
This is a really important concept to understand and plan for BEFORE you start trading. I’m going to say that again. You need to plan this out BEFORE you start trading.
There are a couple different ways to set risk parameters. A lot of traders will use a set amount based on account size. For instance, say you have a $100,000 account. The max you would want to risk per trade is 2%, or $2,000. This is a general rule of thumb. It may even be better to start at 1% if you’re totally new to the markets.
You could also look at using your average daily gain as your stop loss per day. If you’ve averaged $1,000 a day on winning days for the past 3 months, then your max loss per day would be $1,000.
This does a couple things:
- Keeps you from losing more than you are making on average.
- Reduces the size and duration of drawdowns compared to % value of account size.
I know you won’t know what your average is until you start trading, so starting off with a % value of your account size makes sense, but once you gain a track record it’s probably a good idea to switch.
Best Practices for Drawdowns
So you hit a rough patch and have had a few days down in a row. What’s the best way to handle this?
Lets first start by saying that everyone goes through drawdowns. The most seasoned trader goes through them form time to time. It’s a part of trading. But what you do about them, is what separates you from staying in the business or dusting off your resume for the new job you’ll inevitably have to get.
Drawdowns are not fun and they can spiral out of control if you don’t take the correct steps to get out. You may be thinking you need to hit a homerun to make it all back or you go on tilt and start trading every little setup you see.
Don’t do that.
You will dig yourself a deeper hole which will lead to more bad decisions that will worsen the situation.
You need to step back, take a deep breath and reevaluate what’s going on.
Then follow these steps:
- Reduce the amount your risk on a trade and on the day by half
- Focus on selectivity – only take the best setups
- Make sure you are placing hard stops (Place a max loss limit with your broker if you need to)
- Take the base hits – establish some consistency
Once you get back to hitting base hits consistently, you can start to gradually increase risk again.
Similar to a risk management plan, you should have all of this written out in detail and ready to deploy before you start trading real money.
Final Thoughts
Having a risk management plan is of utmost importance. Without it, how will know how much to risk on a trade? How will you know what to do when you are in a drawdown?
Without a plan you are flying blind and heading for trouble. Do yourself and your trading capital a favor – spend some time detailing this all out.
It will pay off in the long run.