What is risk management and how can you apply it to become a profitable trader?
Trading the markets will entail good times and bad times. To survive bad times, risk management is key. As markets are chaotic and unpredictable, the principles of risk management ensures that you remain profitable and stay in the game.
- Back-test your strategy, collect statistics on your performance in demo trading environments and optimise trading strategy.
- Don’t start trading until you have enough capital so you can weather any draw-downs.
- Apply reward-risk ratios in your trading, ensuring your risk is always smaller than your reward.
- Apply leverage sensibly. Start off with 2:1 or 3:1 leverage then work your way up.
- Cut your losses. Make use of stop loss orders, trailing stops, and take profit orders.
- Let your winners run.
Back-test Strategies and Collect Data
The first thing you need to do to manage your risk appropriately is to test your trading strategy out using a demo and collect data on your performance. With no money on the line, you can test and tweak your strategies, and the data you collect on your results can help to improve and iterate your strategy.
For example, one metric worth tracking is your average profitability per trade. You will only want to move over the trading with real funds once your average profitability is consistently positive.
Also, you might want to back-test your strategies on historical data to ensure that they are reliable no matter what the market conditions are. If your strategy works, then you will have confidence applying it to live markets, and back-testing your strategy will also indicate whether it has an edge over the market.
You can back-test your trading strategies on TradingView, TradeStation or NinjaTrader.
Ensure You Are Well Capitalised
Since trading is a game of numbers, you need to be capitalised well enough to weather any storms. Starting with insufficient capital is one of the big mistakes many new traders make.
You need to withstand a losing streak such that you still have enough capital to trade with once the bad times have passed. The reduction in a trading account’s value is known as a draw-down, and these will happen to every trader.
A decent amount of capital is required to start trading and the more money you trade with the more potential profit you can make. Another important consideration is position sizing. If you risk say 10 or 20 percent of your capital per trade, the draw-down would be very severe in the event of a losing streak and would be hard to recover from.
But if you only risk one or two percent of your total capital in each trade, you remain capitalised enough to bounce back from consecutive losses and can come back to the markets when new opportunities arise.
Using appropriate reward-risk ratios can help you remain profitable, even if your win rate is less than 50 percent. The ratio tells us how much your profit if your trade goes according to plan as a ratio with the amount of risk you take for each trade.
For example, suppose you win 40 percent of all trades you make, but your reward-risk ratio is 3:1. For simplicity, let’s assume you only ever cut a trade loose once it is at $100 in losses and exit a trade once $300 in profits are made.
Therefore, 40 percent of the time you win $300, while the other 60 percent of the time you lose $100. Suppose you enter ten trades, winning $300 four times and losing $100 six times.
Overall, you are still in profit despite only winning less than half of the time, since $1200 - $600 = $600. Of course, we are abstracting from trading fees, your average profitability per trade, and so on.
Apply Leverage Sensibly
Applying the highest levels of leverage is a sure-fire way to blow up your trading account. With higher levels of leverage, it takes smaller moves in the market for your position to get liquidated and stacks the odds against your favour.
Therefore, start with lower levels of leverage, such as 2:1 or 3:1, until you build experience and more comfortable using higher levels of leverage. Just because a platform has a maximum level, it doesn’t mean you have to use it. Statistically, you have a better chance of a profitable trade with lower leverage.
Leverage is a great tool that can help you amplify your profits. If you are very certain about a trade setup, then you might want to use leverage a little higher than you usually do, whereas if you are not as sure about a trade and do not want to pass it by, then you can use a lower level of leverage.
Cut Your Losses and Let Your Winners Run
Cut your losses and let your winners run. Knowing when to exit a losing trade is a key skill a profitable trader possesses. By limiting your losing trades as much as possible, you prevent these trades from eating into the profits of your winning trades.
One way to cut your losses is by using a stop loss order, which is an order to exit your position if the price moves against you. You could also use a mental stop loss, a point at which you tell yourself you will exit the position if the market touches that level.
Stop loss orders can prevent you from losing too much money. With stop losses, you can specify the risk you are willing to take, where the risk is equivalent to the difference between the entry price and the stop loss. Ideally, a stop loss should be set in the least obvious place, so instead of at the top of a significant wick, maybe move it a bit higher as using the wick would be an obvious placement.
Trailing stops can protect the profits of a winning trade and allow a winning trade to run. A trailing stop works like a stop loss, but moves up as the market moves up or down as the market moves down. Therefore, a trailing stop can let you run the entire course of a trend, and the dynamic stop loss ensures that you can exit the trade with a profit.
Finally, a take profit order can be used once you enter a trade to exit the position automatically once you have realised some profits. Take profit orders allow you to set up the trade and not have to worry about monitoring the market and exiting once the trade is in profit. By setting your expectations ahead of time, you can avoid getting too greedy and stick to the plan you set out using stop losses, trailing stops, or take profit orders.