Manage your trading risk like a pro

The fastest, simplest and most effective fix your trading has ever seen? Okay, it’s a bold claim … I’ve set myself a big challenge here, but I firmly believe that a few moments spent on risk management can make all the difference to your trading performance.

Most of us start out in trading with a pretty simple approach to trading risk – hopefully we at least know how much we’re risking on a trade … and we calculate that as a small percentage of our fund … but there’s plenty of scope to get smarter …

The only 2 pieces of data that matter

I’m afraid there’s a bit of stuff here about probabilities and percentages – don’t worry, I’m not about to spring calculus on you. I just want to look at two key factors that affect our trading success …

1. Your win rate
2. Your risk-reward ratio

All your winners and losers … your plans for a rosy financial future … your worst-case lose-your-shirt scenario … and everything in between, are wrapped up in those two little bullet points.

So they’re worth some consideration!

Getting it wrong, can make all the difference between your trading system winning or losing, and between you getting wiped out or having a long and prosperous investment career.

First up is your expectancy.

Expectancy is a great tool for checking that your system can actually make a profit.

Expectancy = (probability of winning x average win) – (probability of losing x average loss)

Let’s say that, after reviewing 150 trades, I determine that I’ve won 68% of them and lost 32% of them. My average winner has been £188. My average loss has been £235. This gives me a risk-reward of 1:1.25

I calculate my expectancy like this:
E = (0.68 x 1) – (0.32 x 1.25)
E = 0.28

The higher your E number, the better you’re doing – but any number in the positive territory means that you’re making money.

Next we’ll take a look under the bonnet of your risk-reward profile …

RRR: more dynamic than it looks!

You’ll notice above that I calculated your expectancy from ‘average win size’ vs ‘average loss size’ – rather than simply where you stuck your stops and targets.

This is because, risk-reward ratios can be a lot more active than you might think … and there’s a lot you can do in the management of an open trade to improve this ratio. Even as a set-and-forget trader, there are daily tweaks that’ll boost your E figure.

Let’s consider a trade where I’ve bought with a £2 stake. My stop loss is 100 points below my entry position and my profit target is 200 points above my entry.

I have a 2:1 risk-reward ratio (RRR). I have the potential to win £400 … or to lose £200.

Now the price moves up by 50 points – this is good news for me. My open profit is £100.

But let’s look at what’s happened to my RRR: now I’m 150 points away from my target, and 150 points from my stop. So my RRR is now 1:1.

It’s got worse.

And what if the trade goes against me …? If I move 50 points towards my stop level … I’m 250 points from my target, and 50 points from my stop. So my RRR is now 5:1.

It’s got better!

It can be tricky to grasp how our position gets worse the more profit we move into … but, in fact, the most painful time in any trade’s life is the last few points to our profit target – here we have a couple of points to gain, but have 298 points to lose!

So should we snatch at those profits early? Or lock in a portion of them with a trailing stop? (In a moment I’ll show you why the second option is the better one.)

Now let’s look at when the trade is going against us … as we move towards our stop loss, and our risk-reward profile improves with every £ we lose … the temptation in this scenario is to double down – adding to your position, so you can make even more money when it comes good. While I’ll admit that there are conditions when I do use this technique, it’s not something that I’d generally recommend, as you’re increasing your trading risk … you’re asking for the price to move further … and this trading method can get you into all kinds of hot water!

What I’m getting at here is that risk and reward don’t sit still, waiting for your trade to play out – they are constantly moving. (It’s no wonder most of us are in emotional turmoil as we watch our trades play out!)

Likewise, the money sitting in your open position – whether it’s a profit or a loss – isn’t some abstract concept floating in the ether. It’s real money, that you can take off the table and spend … or a genuine loss that you can settle up and move on from.

Game show money vs real money

We’re often told that open profits aren’t real profits until you’ve taken them off the table.

But that doesn’t mean that it isn’t real cash that’s sitting there waiting for you to pick up.

I’m sure you’ve seen the game shows, where our contestant has just won a heap of prizes … and is then offered the chance to double them on the answer of one final question …

Does he stick with what he’s got?

Or risk it all in the hope of getting more?

Inevitably, with a studio audience baying at him to ‘play’, he’ll take the gamble, with some comment along the lines of ‘I came with nothing, so I’ve nothing to lose’.

It’s dreadful logic. Most of us wouldn’t gamble a £20,000 car on the off-chance of upgrading it to a car and a holiday and a cash prize … would we?

Just because he hasn’t yet got the keys in his pocket and driven it away, doesn’t mean that it’s not really his for the taking.

My point is that we tend to underestimate the value of our open profits … and we don’t fully appreciate the costs of our open losses.

And it makes us very blasé about them, and happy to gamble them away.

So, is the answer that we should take profits sooner … and cut losses faster …? Where does that lead us …?

Intervening in our trades … does it help?

So, if you follow my logic above, you’ll probably be thinking that you should take profits much sooner.

But what happens to my risk-reward ratio when I start closing out a profit before it’s reached its target? My risk-reward ratio gets worse. Going back to my earlier example of a trade with a 200-point target, and a 100 point risk … if I close this trade after I’m 100 points in profit, then my risk-reward has moved from 2:1 to 1:1

This isn’t going to help my expectancy figure – in fact, it could tip my profitable system into negative territory.

But if we cut our losses sooner … that has the effect of improving our risk-reward ratio. So, if you can spot a trade that’s gone awry before the stop is hit – then you have a great chance to boost your overall performance.

(If you’re a Diff Code trader, you’ll be familiar with closing open trades on a change of direction, which, over the long term massively improves the risk-reward profile of the system.)

So, we can cut our losses early … but how do we protect our open profits?

And here rides in our hero on his white charger … the trailing stop.

The trailing stop is all about reducing trading risk.

Yes, it can lock in our profits too, which is great. But viewing your trailing stop as a profit-taking tool is asking too much of it – and is why I was getting so frustrated with my trailing stops.

Instead, consider every point it moves up your trade, is a notch up the risk-reward ratio – and an extra bonus on your expectancy figure.

I strongly recommend combining trailing stops with a sensible profit target – that way you’re not over-dependent on them, and won’t always be giving back a portion of profits before you’re closed out.

Locking in profits and stemming losses longer term

So, our trailing stops can lock in profits on individual trades … but there’s another factor that can have a serious negative effect on long term profits: volatile returns.

These are the ups and downs on your profit chart – they’re an inevitable part of trading (we can’t win every trade), but there are some really good reasons to try to smooth them out …

Volatile returns suck financially and emotionally: if you’ve ever had a losing run, you’ll know all too well about the emotion turmoil it causes, and the pain to your bank. But, even in a very profitable system, these ups and downs will damage your long-term compound returns (I show exactly why here).

So, smoothing out the curve won’t just help your nerves – it’ll improve your long-term wealth.

To do this, we apply the same principles as the trailing stop, and the early close, but long-term in the form of …

1. Maximum drawdown limits
2. Cutting risk in losing runs by reducing stake size

You can get lots of information about drawdown limits HERE.

And reducing stake sizes in a losing run is a trick straight out of the Turtle Traders handbook: each time you lose 10% of your trading fund, then reduce the notional size of your account by 20%.

Here’s how it works in practice:

If you had £10,000 in your account, and were risking 2% per trade, that would be £200 risk per trade. But if your fund reduced to £9,000, you’d cut your risk by reducing your notional fund size by 20%, to £8,000. So you’d be risking 2% of £8,000 = £160.

If you drawdown further, to £8,000, then you’d reduce your risk again, risking 2% of £6,000.

It’s a financial form of ‘battening down the hatches’ in rough times, and is a great way to preserve your wealth.

Losing runs are a very normal part of trading – they are a statistical certainty, so we shouldn’t read too much into them. How often you can expect them, and how long they’ll last will be affected by your system’s win rate. But – of course – they’ll come along when they want to, not when you want them to.

The trick is to be prepared for them … think in big sample sizes, not individual trades … and always question your actions: ‘am I helping my expectancy, or hurting it?’