Risk Management
Chapter 1
This is a series of articles which will take us on a trader’s journey to learn how to manage risk and become a profitable trader.
Preface
In the world of trading, the road to success is often paved with many unexpected twists and turns along the way. Many embark on it hoping to gain financial freedom, only to find themselves faced with new challenges and decisions they hadn’t anticipated. This series of articles aims to clarify some of the key aspects of trading that are often misunderstood or overlooked, and to serve as a guide along the way.
Risk management is one such aspect. It’s the focus of this article. While its importance cannot be overstated, it may not be the most glamorous part of trading. It is the backbone of any successful trading strategy, and without it, even the most promising trade can quickly go sour.
We aim to demystify the concept of risk management. We break it down into simple, actionable steps that any trader, regardless of experience level, can implement. We will attempt to give you a comprehensive overview of the critical components of effective risk management, from understanding the importance of a stop loss to knowing how much risk you are willing to take per point.
The Why?
Risk management is a critical component of successful trading for several reasons:
Capital preservation: Protecting your trading capital is the primary goal of risk management. By determining in advance the maximum amount, you are willing to lose on a trade, you can ensure that your trading will continue even after a loss.
Loss Mitigation: Not all trades are going to be successful. Managing risk allows you to limit your losses on unsuccessful trades, ensuring that a single bad trade doesn’t wipe out your profits.
Emotional Control: Trading can be an emotional Endeavor. By setting pre-defined risk parameters, you can remove much of the emotional decision-making involved in trading. This helps prevent decisions based on fear or greed.
Longevity in trading: Effective risk management promotes trading longevity. It allows you to withstand the volatility of the market and continue to trade over the long term.
Profitability: Finally, by effectively managing your risk, you will increase your chances of being profitable in the long run. It may limit your profits on individual trades, but it also limits your losses. This can lead to better overall profitability.
Remember that the key to successful trading is not only to maximize your profits, but also to minimize your losses. That’s where risk management comes into play. It’s not just a strategy. It’s a way of thinking. You set yourself up for long-term trading success by adopting it.
Why do the +95% of traders fail to trade for a living? One of the reasons is that sometimes they keep adding to their losing trades. They keep extending their stop loss because they keep dreaming that the market will listen. Also, many rush to cash in on their profitable trades too soon, instead of letting the high momentum trades run its course, -scale in and/or -scale out.
The How
Let’s look at some of the healthy habits traders need to adopt to help manage risk. The first one is Position Sizing.
Size is of uppermost importance because the downside can only be a 100% while the upside is unlimited.
Position sizing
Position size is the thing that has the most impact on your trading performance. If you trade with a large number of contracts, you risk completely blowing your account. On the other hand, if you trade with a position size that is too small, it will take forever for your account to grow. So, what is the perfect balance between risk and reward?
Well, there really is no simple answer. It depends on your strategy, mindset, and risk tolerance. However, I will try to go through some different strategies and give an idea when each might be appropriate.
Fixed Tick Size
If you’re a scalper looking to quickly enter and exit the market with profit, you could use your platform’s Bracket Order/ATM to set a fixed Stop Loss and Profit Target.
Let us take an example from the real world, where you might be trading on the NQ. A trade entry is coming up. You have decided to use the famous 5n5 rule. This is a SL of 5 points (20 ticks) and a profit target of 5 points (20 ticks).
This would be risking $100.00 USD and targeting $100.00 USD on a NQ e-mini contract. So your ratio of risk to reward will be 1:1. This means that you would need to win more than 50% to be profitable. If you change Stop Loss to 15 ticks and keep your Profit target, you only have to win more than 43% of the trades. Stop Loss at 10 ticks would require +34% win rate. Stop Loss at 8 ticks requires +29%.
Formula to calculate this is: Required Win Rate = 1- Profit Target / (Profit Target + Stop Loss)
Without considering the entry setup, you cannot simply adjust your stop loss. Your trade may need 20 ticks of space to move before your profit target is reached. Do some proper back-testing. This will help you find the right stop loss for your strategy using a fixed tick size.
You also need to consider the size of your account. Do you have $10,000 to draw down, or maybe $2,000?
You can easily lose 20 consecutive trades you make. This could happen if the markets are difficult and you keep trading to recover your losses. It could even happen to you if you only trade 3 times a day. The market just decides to behave differently and then your strategy does not work. A loss of $100 20 times is a loss of $2,000 USD. Then your account is blown. If your drawdown was 2k from the start. One way to be able to deal with this situation is to do the following:
You have a drawdown of 2,000 USD and you want to risk only 30% of that amount with 20 trades. This means that you can risk 600 USD / 20 trades = 30 USD risk per trade. If your strategy dictates a stop loss at 20 ticks, then you need to trade the MNQ (micro contract). You should use 3 MNQ contracts per trade to follow this rule. 1 contract = $0.50 per tick. This way you will be able to trade the market for a long period of time, even if you hit a bad sequence of trades. Once you have traded 10 times, you can recalculate and see if it is possible to scale up to 4 micro-contracts per trade.
Fixed Tick Stop Loss with a Twist
This strategy is often used by users in BluSky’s live trading room. There you can get more information and listen to other traders’ experiences with this strategy. There is one trader who has extended this with a trailing stop to try to capture a bit more profit when the market has momentum. If you hit the 20 ticks target, it will move the stop loss 3 ticks for every 2 ticks movement until the stop is triggered or the profit target is triggered at 90 ticks.
This could maximize your profits and you can get the template for NinjaTrader in the Live Room. Be sure to back-test it before using it to trade with. Just ask for it in the chat.
Stay tuned for more as this series continues…