What Is Risk Management?
The only way we can make money in the markets is if we're willing to put some of our money at risk.
That means, we have to take on the possibility of losing money for the opportunity to make a return on our capital. Therefore, we're at our most vulnerable when we have a trade open.
Many traders obsess over the potential returns they can make from their trades and this is what leads their decision making; how much money they could make. However, this is usually a recipe for disaster.
Instead, if you want to succeed as a trader and enjoy a long-term career, you need to obsess more about the potential downside of your trades as your priority. That's where risk management comes in; the measures you take to limit your potential losses.
Although there are lots of complex ways to track and manage risk, we can achieve our goals just by keeping things simple. With that in mind, there are two basic questions we need to ask ourselves before opening a trade:
- How much money (or what percentage of my capital) can I potentially lose if the price moves against my trade?
- What is the probability of a loss happening?
This guide will get you on track for being able to answer those questions and start getting your trading risk under control.
Why Is Risk Management so Important?
Without any risk management in place, you're essentially risking your entire trading account on each trade you take. That sounds ridiculous, but a lot of beginner traders make this mistake and end up burning out their account. I can tell you from experience, it's not a nice experience and ideally you'll want to take this lesson on board now rather than having to learn it the hard way!
Another issue for a lot of traders is that they do implement risk management, but the risks they're taking are still too big. There are a lot of problems that can be caused by this, but let's just focus on two: the difficulty of earning back the capital and the psychological aspects.
The difficulty in overcoming a big drawdown
When you lose money, the total amount that your account is down from its peak is known as your drawdown. For example, if you lose a few trades in a row and it adds up to 5% of your account, your account has a 5% drawdown.
Drawdowns are normal in trading because losing trades is a necessary part of successful trading. However, the bigger a drawdown gets, the more difficult it is to bring your account back to its original balance.
Take a look at this table:
That table shows you the return you would need to earn to bring your account balance back to where it started (break-even) after different levels of drawdown. As you can see, the bigger the drawdown gets, the more out of control the required return becomes.
Therefore, to avoid our drawdowns getting so big that recovering is an impossible task, we need to keep our risk management under control.
The majority of issues traders encounter that lead to negative performance are psychological issues. There are lots of ways we have to learn to control or overcome our own impulses if we want to succeed in the markets.
Most psychology-related trading issues are actually symptoms rather than being the root cause. There are many of these symptoms, but when you break them down you realise there are only a small number of root causes.
One of the biggest root causes is the amount of money at risk. When the risk is high, our emotions and other biases flare up.
The work of behavioural economists and psychologists such as Daniel Kahneman and Amos Tversky has found that humans experience a phenomenon known as loss aversion. This is our tendency to avoid taking losses, since the impact of a loss is more powerful to us than the impact of a gain of equivalent value.
As I mentioned before, being able to take losses is an important part of trading, so we have to overcome our loss aversion if we want to trade well. This is easier to do when the amount at risk is lower, but if the amount at risk is higher our loss aversion will be overwhelming.
It's at this point we begin to take actions to avoid accepting the loss that only end up being self-sabotage. For many traders, this becomes the equivalent of having no risk management at all and it ends up with them burning out their account.
So if we want to trade as rationally as possible and have the best chance of succeeding, we need to adopt appropriate risk management.
How Can You Manage Your Risk?
There are many ways to measure and manage risk, including some extremely complicated ones. However, we prefer to keep things as simple as possible for our trading because there's a pay-off between adding additional complexities and actually being able to trade fluidly in the markets. Beyond a certain point, over-complicating things just leads to diminishing returns.
The best place to start is by going through a calculation known as 'The Trader's Equation'.
The Trader's Equation
As I've mentioned before, to succeed in trading you need to take losses. This relates back to the old trading maxim which states that to be a good trader you need to "cut your losses and let your profitable trades run".
Therefore, successful trading will rely on the combination of three factors: profit, loss, success rate.
This means, in theory if you want to increase your profitability you can either:
- Increase the amount of profit you take from profitable trades
- Decrease the loss you take from losing trades
- Increase your success rate so you have a higher rate of profitable trades
- Achieve a combination of the previous three points
The reason I said 'in theory' is because, in reality, achieving one of the above points will usually come at the expense of one or more of the other factors.
This is something we need to keep in mind as we work on risk management. We're trying to achieve number 2: 'Decrease the loss you take from losing trades', but we need to achieve this without affecting the other factors so much that we end up with a negative outcome from the Trader's Equation.
To keep things simple, the way we will look to manage our risk is by paying attention to three things:
- Stop loss
- Position size
As we go through each of these, I'll explain the balancing act we need to play in relation to the Trader's Equation so you can make appropriate adjustments without killing your profitability.
What is a Stop Loss?
A stop loss is an order that we place with our brokers to automatically close part or all of our trade at price we have chosen. For example, if I enter a long trade at $1.085 I might choose to set a stop loss at $1.050 to protect my downside. As soon as the price touches $1.050 my stop loss may be executed. (Note: I say 'may' because sometimes this does not happen. We will discuss this later in the 'volatility' section).
We would usually think of our stop loss in terms of pips or points. For example, I might think of my stop loss as being 35 pips below my entry price. Thinking of it in this way helps for calculating your overall amount at risk, as we'll go through a bit later.
Some people don't like to use stop losses as they believe it reveals their position to the market and leaves them vulnerable. Even if you feel this is the case, we recommend placing a stop loss even if it's much further away from where you intend to exit. This will act as a safety net in case a bad situation occurs where you're not able to exit a trade manually.
Stop Loss Example
Imagine we are entering a long trade based on the price interacting with the pink swing low.
Based on our analysis, we may feel if the price passes below the red line labelled stop loss the opportunity is no longer valid for us. Therefore, that's where we place our stop loss and if the price moves through that point we can be automatically taken out of our trade at a loss.
Where Should You Place Your Stop Loss?
There are many different approaches to stop loss placement and some are more effective than others.
The most basic and common method is to use a 'static' stop loss. This means always using a similar stop loss size regardless of the opportunity or context in the market.
Unfortunately, by using a static stop loss, you're more likely to have the stop loss placed incorrectly than correctly. Most of the time it will either be too close, meaning you'll be 'stopped out' unnecessarily and therefore restrict the potential of your opportunity, or it will be too far which means you're taking on more loss than you need to when an opportunity has failed.
Instead, we prefer to use a dynamic stop loss that's based on the opportunity.
With the Duomo Method, we place our stop loss slightly further than what we refer to as the trade tipping point. This is the point beyond which we feel the opportunity is no longer valid and we don't have a good grasp of the probability of the situation, or where any further movement no longer makes sense as an opportunity.
Using a Soft and Hard Stop Loss
With the Duomo Method, we differentiate between a soft and a hard stop loss.
A soft stop loss is also known as a mental stop loss. It's a decision you've made ahead of time to close the trade manually if certain criteria are met. However, we must only use this when we also have a hard stop loss too.
A hard stop loss is a regular stop loss that we've already discussed. The order is placed in the market and you're automatically taken out of the trade.
The reason we use these two stop losses is to allow for fluctuations around a significant level.
For example, I might say that I'm happy for the price to fluctuate around a significant level but if it closes through it, I want to exit my trade. Therefore, I need to use a soft stop loss so that I can allow the fluctuations to happen without the stop loss being triggered, but as soon as I see the price close through the level I manually close the trade.
However, at the same time I will need to use a hard stop loss as a safety net. I'll place this stop loss at the point where I believe the price can no longer return to the other side of the significant level before the time it will close. In other words, I'm pre-empting that I will be triggering the soft stop loss anyway and I don't want to risk the price moving further against me.
How Stop Losses Affect the Trader's Equation
Let's assume that we've kept all other aspects of our trade the same, but we've adjusted our stop loss.
If the stop loss is now too tight, it will mean it might get triggered unnecessarily when the opportunity is still valid. Therefore, it will reduce how much we lose on each trade, but will also reduce our success rate. It might be the case that this negatively affects our Trader's Equation.
If the stop loss is now too wide, it will mean we might still be in a trade unnecessarily even once the opportunity is gone. Therefore, it will increase our success rate as there is more chance for a trade to return to a profit, but since we are taking a bigger loss when a trade ends up losing it may negatively affect our Trader's Equation.
Therefore, we need to make sure the stop loss is positioned appropriately to not kill our success rate or lead to huge losses when a trade loses.
To understand more about stop losses, check out the video below:
What is Your Postion Size?
Your position size is the amount of the asset you are buying or selling. This determines how much profit or loss you make for each price movement and therefore decides how much you might lose or earn on an opportunity.
For example, if I open one standard lot on a long EUR/USD trade, each pip will be worth $10 to me.
If the price moves 10 pips into profit, I will now have $100 in profit.
However, if the price moves 10 pips into loss, I will have a $100 loss.
Therefore, in terms of risk management, the combination of your stop loss and your position size will determine the amount you have at risk.
If you have three standard lots, you're exposed to $30 per pip. If your stop loss is 15 pips away, that means the amount you could lose is $450.
How Much Should You Risk per Trade?
Just like when we discussed your stop loss, there are also many different approaches to choosing a position size.
A lot of people will choose a static position size, which means they open the same size position for each trade. However, there are downsides to this.
If they use the same position size for each trade, it means the stop loss is determining the variability in the amount at risk. For example, if they open one standard lot and the stop loss is 10 pips, they have $100 at risk. If they open one standard lot and the stop loss is 30 pips, they have $300 at risk. But what if the $100 trade is actually the better opportunity? They're risking more on the opportunity that is less favourable.
Instead, we prefer to use a dynamic position size where we choose the amount at risk based on the potential success rate of the opportunity.
Important: notice I said the position size is based on the potential success rate not the potential amount of profit.
We usually think of the amount we're risking as a percentage of our trading capital. As a hard rule, we never look to risk more than 2% on any opportunity. That means, the very best opportunities will be 2% at risk (or closer to that amount) and other opportunities will warrant a lower percentage at risk.
If you want to know why we risk no more than 2% per trade, check out this video:
Calculating Your Position Size
There are two things you need to decide before you know your position size, and both of these should be based on the opportunity. The first thing is the placement of the stop loss (or where you will be exiting the trade in a loss, if you prefer not to use a stop loss) and the second thing is the percentage of your trading capital you will risk.
From these two factors, you can calculate the position size you need to open.
Total trading capital: $100,000
Stop loss: 20 pips
Percentage to risk: 1%
We can start by calculating what capital amount we are risking.
$100,000 x 0.01 = $1,000
If we're risking 1%, it means we're risking $1,000. Now we want to know how much that means per pip.
$1,000 / 20 pips = $50 per pip.
Now we just need to figure out how much of the asset we need to buy or sell to make it $50 per pip.
If 1 standard lot = $10 then to achieve $50 per pip we need to open 5 standard lots.
For more information on how to calculate your position size, check out this video:
How Position Size Affects the Trader's Equation
The way your position size affects the Trader's Equation is much more simple than for stop losses.
If you increase your position size, it will increase the amount you can make if your trade is profitable. However, it will also increase the amount you lose if the trade is a loss.
Likewise, if you reduce your position size, it will reduce the amount you can make if your trade is profitable. However, it will also reduce the amount you lose if the trade is a loss.
Therefore, the best way to improve your Trader's Equation is to risk less on opportunities that have a greater chance of losing and risk more on trades that have a greater chance of profiting. This is why we always base the percentage at risk on the probability of the opportunity rather than the size of the potential return.
Being Careful About Volatility
The final point we need to be aware of is volatility. In trading terms, this refers to how sharply the price is rising or falling.
When volatility is high, it means the price is rising or falling by larger amounts than usual in a short space of time. This can be a risk factor for us as it might mean the price can move against us quicker than expected and quicker than we can react to get ourselves out of our trade.
On most occasions, by having a stop loss you can protect yourself against these sudden and often unexpected moves. However, sometimes a stop loss is still not enough.
When the price is moving particularly rapidly you may encounter slippage, which is where the price moves as your trade is being executed (including exiting the trade) and ends up giving you a worse price than you wanted. But in really bad situations, you might find that your stop loss doesn't get triggered at all! This can lead to disastrous consequences.
It's not possible to anticipate all moments of high volatility but we should avoid those we can.
For example, when big economic data releases are hitting the market, we know there is going to be a surge of volatility as the market digests the news. If this doesn't fit your style of trading, it would be better to avoid trading during those times and close any open positions.