There is risk in trading with every order you execute. As a trader, your profitability rests on a watertight risk management strategy that protects your trading bank.
At the core of risk management in trading is the goal of limiting your losses and maximizing your profitable positions. Within this article, we’ll explore some of the typical risk management strategies and techniques used by financial traders, and the steps you can take to create your own risk management plans as a trading novice.
This article at a glance:
- Traders need to be objective rather than emotional, when making trading decisions.
- A risk management strategy helps you mitigate losses while making full use of profit potential.
- Common risk management strategies include the 1% rule, risk-reward ratios, and the Kelly Criterion model.
Why should I have a risk management strategy?
Even the best and most profitable financial traders need a risk management strategy to ensure their accounts live to fight another day. Traders need to be objective and calculated in the markets. A risk management plan is a proactive way to do this, based on an acceptable risk-reward ratio.
There is a famous saying among financial traders that you should “plan your trades and trade your plan”. With a risk management strategy in place, you should be able to quickly determine your maximum loss and potential profit. This helps to remove emotion from your trading, allowing you to think clearly and methodically amid the noise of the markets.
Common risk management strategies in trading
The 1% rule
The 1% rule is popular among day traders. This approach restricts you from entering no more than 1% of your available trading capital towards a single trade. You would effectively need to have 100 consecutive losing trades for your trading account to be in jeopardy.
Trading with a risk-reward ratio in your favor
Define a risk-reward ratio that enables you to be profitable. The risk is the price movement between your entry price and stop loss price. The reward is the price movement between your entry price and the take profit price.
Let’s say you were trading the share price of Amazon. You enter a long position at 3100 with a stop loss at 3050 USD and a profit target of 3200 USD. You essentially have a risk-reward ratio of 1:2 – risking a 50-point loss for a 100-point profit.
When trading with a risk-reward ratio of 1:2, you would break even with a strike rate of 33%. Your strike rate needs to be 34% or greater to be profitable in the long term. The lower your risk to reward, the higher your strike rate needs to be for you to be profitable. If your risk to reward ratio is 1:1, you would need a minimum of a 51% strike rate to be profitable over time (as 50% would be your break even point). The higher your strike rate and higher your risk to reward, the large your profits will be.
Position sizing based on the element of risk involved
Optimizing the size of your trading positions based on the inherent risk in the market is another popular risk management technique. Many traders rely on the Kelly Criterion model, which states that position sizes should be proportionate to the expected outcome.
The Kelly Criterion uses winning probabilities and win/loss ratios to tell you what percentage of capital you should commit to an asset.
For example, if you thought the safest place to put your stop loss was 100 pips away and only wanted to risk 50 USD on the trade, you would choose to place 0.50 USD on each pip. Whereas if you thought that the best place to place your stop loss was 50 pips away, you would change your position size to 1 USD per pip. In both these examples, you would have the best placed stop loss for the trade, only risking 50 USD on each trade.
Creating your risk management strategy
Follow these three steps to start building initial risk management strategy:
- Use risk-reward ratios that don’t thwart your upside potential. Undertake cost-benefit analysis to reach a healthy risk-reward ratio that limits your losses but allows your profitable positions to run far enough to outweigh the losing trades. Write this ratio down in black and white. Consider it your starting point for any trading decisions. A word of caution for beginners – always try to have a risk-reward ratio above 1:1.
- Consider hedging as a means of offsetting open positions. Look at hedging your initial investments by opening positions across more than one asset and instrument.
- Take your own ‘stress test’. Carry out your own stress test. Measure the worst-case scenario loss and decide whether you could handle this hit to your capital. Trading at a level where you are comfortable with the losses you experience is a step in the right direction.
This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. INFINOX is not authorized to provide investment advice. No opinion given in the material constitutes a recommendation by INFINOX or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.