i. Risk is inevitable and the best and the only thing a trader can do is to manage it.
ii. Never risk more than 1-3% of the capital in any trade.
iii. Risk management is the only holy grail in trading.
iv. Stop loss and position sizing are two methods of managing risk.
What is risk?
Risk can be simply defined as a possibility of a loss, the loss could be financial or maybe something else but for the purpose of this blog post, we will only stick to financial losses.
For instance, in poker or blackjack, the player is dealt some cards and is then supposed to bet on how strong their cards are. They then have to bet on their odds of winning by putting in some money.
Whenever a trader takes a trade, they are basically betting that the price of the financial asset they are trading will move in a certain direction. They do so by putting money at stake.
It should be noted that trading is not gambling and I took the examples just for the sake of illustration. Trading does involve speculation but it is to be an activity of organized speculation.
No reward can be gained without any risk and in trading there is always an imminent risk of losing money. It then comes down to the trader whether to take up a big risk or a limited one.
This is where risk management comes into play and like I mentioned earlier, it is the only holy grail in trading.
How is risk managed?
The first step to manage risk is by identifying the risks one might be exposed to. If you don’t know that you have a problem then you won’t be able to solve or manage it.
Managing risk is the act of containing losses. This act applies to trading, blackjack, poker everything where risk is taken to get some reward in return.
It should always be noted that no matter how good a strategy one has that might allow them to capitalize on price swings but if they do not manage the risk properly then it will all be a waste.
Traders must determine a risk parameter before they enter into trades. They must set a limit on how much of their capital will they be comfortable with if it’s lost.
Once these things are thought out properly, the rest just falls into place on their own. Risk limits may differ from trader to trader as not everyone has the same risk tolerance.
Like its widely said that never risk more than 1-3% of the capital in any given trade, one trader may stick to the 1% risk throughout while another might go on and risk 3% on all their trades.
When it comes to position sizing, this is the closest one can get to a holy grail. Position sizing is the best way and the most complete way by which traders can manage and limit the risks they are exposed to in the financial markets.
Position sizing is basically loading up the appropriate quantity of the asset being traded while taking a trade. Here appropriate quantity will depend on how risk-averse the trader is.
As I mentioned earlier that traders must not risk more than 1-3% of their capital on any given trade, this alone is not enough to determine the size of the position.
Traders also need to have a stop loss limit in place. Stop loss is the defense of the trader in the market that allows him to cut off the position before the price shoots off in the opposite direction of his trade.
In order to get the proper position size traders would then divide their risk limit with the stop loss amount. This would then give them the exact quantity they must either buy or sell accordingly and get into the trade.
For instance, trader A trades with a capital of $100,000. He is a moderately risk-averse person and does not risk more than 2% in any trade.
This amounts to $2,000 that he is comfortable with losing on any given trade.
He identifies a potential long setup on a financial asset that he tracks regularly and works out a trading plan. He decides the entry, take profit, and stop loss price levels.
According to the trade plan he worked out, he must take a $20 stop loss and aims for a 1:2 risk to reward on the trade. Does this mean that he will risk $20 to earn $40? No, he hasn’t sized up his position yet.
He knows that he cannot risk more than 2% that is $2,000 on the trade and has a stop loss of $20, on dividing the two he now knows that he can buy up to 100 quantities of the financial asset.
By doing this he is well within the risk parameters he has set for himself and can get into the trade, sit back and let his plan play out.
Irrespective of the outcome of the trade, whether price hits the take profit level or even the stop loss, the trader is assured that he will not lose a chunk of his capital.
Putting this in terms of a formula,
Position size = (x% of Capital) / SL amount
x% is the amount the trader is ready to risk of his capital
SL amount is the total money value of the stop loss of the trade
The holy grail
Risk management and position sizing are the only holy grail in trading. We have said this multiple times already and will keep saying it as not all traders grasp it.
Instead of searching for a full-proof strategy, invest your efforts in getting the habit of managing risk every time you take a trade.
Whenever we place a trade, we have no control over its outcomes. We can just find a trade with a good probability of it moving in our favor and then wait for the probabilities to play out.
This is something that we cannot influence but we sure can control the risk we take. Setting priorities right is not just important in trading but in life too. In trading, the number 1 priority must be to keep risk at a minimum.