My step-by-step guide to building your trading risk management strategy

 

I’ve gone on a lot about risk and how to manage it in the past, but what I’ve realised is lacking on the Trader’s Bulletin site (until now) is a comprehensive how-to on risk management – from the basics, to building a proper strategy that’ll manage your risk on trades you’re placing right now – and will carry your strategy through into the future.

Why do I need a strategy to manage my trading risk?

As soon as we have any possessions or money – it’s at risk. It’s at risk of being stolen … of failed investments … and even if we put our money in the bank, it’s still at risk of inflation.

Risk, of all types, is around us, every minute of the day. And, in order that we don’t become paralysed by the task of balancing risks, we get used to managing decisions with gut reaction rather than weighing up lists of pros and cons.

But our gut reactions aren’t very good when it comes to managing financial risk, and can get us into all kinds of trouble.

Poorly managed risk has a number of effects:

• Profits that are too small
• Losses that are too big
• Returns that are too volatile
• Stress and sleepless nights

Ultimately, these things will lead to suffering a large drawdown of your trading  bank – or wiping it out completely – and giving up on trading.

The brutal truth is that this is the journey that too many novice traders take, ending up poorer and disillusioned.

The good news is that it doesn’t have to be this way. If you follow the simple steps to manage your trading risk, you can have a smoother path to trading success, and a lengthy, prosperous trading career.

Always trade with a stop loss

This really goes without saying. A stop loss means that your trade will be automatically closed out if the price moves against you. If your stake is £1, and the distance to your stop is 20 pips, then your risk on that trade is £20.

Stop levels aren’t infallible. They can suffer slippage, which is when the price is moving too quickly at your broker isn’t able to fill your order at the right price. You can protect yourself against this with a guaranteed stop level, however, these are expensive, and have little flexibility.

Only trade with money you can afford to lose

It’s a golden rule of investing that we should only trade with money we can afford to lose. We’ve probably all heard that so many times, that we don’t really ‘hear’ its meaning any more.

How do you decide how much you’re prepared to lose? And are we really prepared to lose all of our pot? Many people will throw in the towel after a drawdown, long before their pot is wiped out. This is because drawdowns lead us into self-doubt, and we worry about throwing good money after bad.

It is the nature of investing that our profits don’t move in straight lines – it’s the acceptance of those ups and downs that gives us the opportunity to make superior returns. But the flipside is that we have to stomach that upheaval.

If we trade too big for our comfort, we risk losing more than we can afford to lose. If we trade too small, we unlikely to care enough about our trading and will question if it’s really worth the effort.

As your trading experience grows, you can expect to gain in confidence. I recommend starting small and reevaluating your bank size periodically so you can add to it. Even adding a modest amount to your trading fund, on regular basis, can have a staggering effect on your returns. If you need to see proof of this, please check out the chart on this page.

Follow the 2% rule

Fixed fractional money management is the fancy name for what’s more commonly called ‘the 2% rule’.

The 2% rule is that you should risk no more than 2% of your entire pot on any one trade. So, if your fund is £5000, then your maximum risk per position should be £100. This is NOT your stake size – it’s the maximum loss you could take.

So, if your stop distance is 20 points, then your stake would be £5, giving a maximum potential loss of £100.

The best thing about using a fixed fraction of your fund like this is that your risk will naturally contract during any drawdown. Going back to the example of £5,000 with a 2% risk per trade … if you (heaven forbid) lost 50 trades in a row, you wouldn’t be down to zero, because your risk per trade would have got smaller and smaller as your bank size shrank. After 50 losing trades in a row, you’d be down to a bank size of £1,820.

Of course, if you’ve lost 50 trades in a row, I’d suggest there’s something very wrong with your trading strategy! But there will be losses along the way, and we need to be prepared for them.

Trading losses are an inevitable part of any trading strategy. Many very profitable systems can lose more than 50% of their trades, and the higher the percentage of losing trades you have, the more likely you are to have long losing runs. If we’re prepared for this, and have built it into our risk management – there’s no reason for it to faze us.

Fixed fraction risk also means that you can be consistent across your trades. And by risking just 1% or 2% per trade, you’ll have a good buffer so you can take losses without suffering a significant drawdown.

Avoiding big drawdowns isn’t just about keeping your sanity – a smoother profit curve will also make you richer in the long term.

Calculate your stake every time

This is then next step on from the 2% rule. Every trade we take, we should look at our pot size, measure our risk based on the percentage of that pot we’re prepared to risk, and divide that figure by our stop distance.

So if my pot size is £5,200 and my risk profile is 2%, then my risk per trade is £104. If the setup has a stop distance of 50 pips, then my stake will be £2.08

Or, if my pot size is £9,760 and my risk profile is 1%, then on a trade with a 30 point stop distance, my stake should be £3.25

This quick calculation on every trade should be second nature. If you have any doubts about it, you can use my free position size calculator HERE.

Will you withdraw your winnings or reinvest them?

By reinvesting your winnings back into your trading fund, your fund will grow, your stake sizes will gradually increase … and your fund will get bigger, faster. Combined with fixed fractional money management, it means that your risk per trade might be £100 this week … £102 next week … £104 the month after …

 This subtle process of compound investing is incredibly powerful.

However, there’s no rule that says you need to reinvest your winnings – perhaps you’re happy with the amount you have in your fund, and you’d rather spend those gains. It’s your money!

You could also consider adding a throttle to your compounding, which can be a nice balance. This means you’re reinvesting some of your winnings, but not all of it. You can find out more about this method HERE.

Use drawdown limits

Drawdown limits are a useful way to stem losses. They work by setting a limit on how much you’re prepared to lose in a day … a week … a month. When you hit that limit, you stop trading.

Many people push against this – there’s a strong urge to ‘win back’ those losses. But often a string of losses is telling us that market conditions just aren’t right for us today. By stemming losses now, we’ll be able to come back to the markets tomorrow without too much of a drawdown on our account.

If you don’t want to stop trading completely, you could half your stakes until you get another winner. If you have another loss – half them again. If you’re compounding your winnings, you’ll find that a smooth profit curve makes you more money, faster, than a profit curve that jumps about.

Beware correlated markets

Market correlations can be tough to measure and balance, but it’s easy to avoid serious pitfalls here.

Global markets tend to move in unison. If the value of Wall Street drops, the FTSE and the German DAX won’t be far behind.

So, if you’re holding multiple positions, try to be aware of which instruments may be correlated. If you’re long the FTSE and the DAX, then you’ve double the exposure on indices. Likewise, if you’re short on EURUSD and GBPUSD, then you’re doubly exposed to dollar strength.

Calculate your risk-reward ratio

Everyone involved in trading will have a view on risk-reward ratios … what’s right … what’s wrong …. Here I’ll look at how to calculate yours, what it means, and what the pros and cons of a higher or lower risk-reward ratio are.

Your risk-reward ratio (RRR) for any individual trade will be the potential reward on that trade compared with the potential risk. So, if your stop distance is 25 points, by the distance to your target is 50 points, your RRR is 1:2 – i.e. you expect to win 2x what you could lose.

But risk-reward ratios across all your trades is likely to look different. How does your average win size compare with your average loss size. This will show up where you’ve taken profits early – which will show as a reduction in your reward-to-risk. It will show up if you’ve been tightening in stop levels, which should boost your reward-to-risk figure.

The best way to keep tabs on your average RRR is with a simple spreadsheet, like this one.

Many traders swear by a RRR of 1:2 or greater – so their average win size should be at least double their average loss, with many claiming they’ll only take opportunities of 1:3 or 1:4.

This is nice work if you can get it!

These kind of trading opportunities don’t come along that often, and it’s a bar that is tough to maintain. With my Heikin Ashi Mountain system, I have an average win size of £211.96, compared with an average loss size of £92.60, so I’m just nudging in above the 1:2 standard.

However, I don’t maintain this for all of my trading, and I really don’t feel that it suits all trading styles. The higher the reward to risk you demand, the lower your success rate will naturally be, and it’s important to find a balance that suits you. I have in the past also trading with an RRR of 2:1, which means each loss was double the size of each win – this kind of trading tends to have very high success rate, but it’s really important to maintain that or losses can quickly mount up.

My advice when you’re starting out is to aim for somewhere between 1:1 and 1:2, and to keep monitoring it, along with your all-important success rate …

Monitor your success rate

Your risk-reward ratio is meaningless unless it’s balanced with your success rate. You can have an amazing RRR, with winners 3x the size of losers, but if you’re only winning 25% of your trades, it isn’t enough to turn a profit.

Likewise, you may have a low RRR of 2:1, winning £10 for every £20 risked. But if your success rate is 70%, it’s a strategy that can do nicely for you over the long term.

Again, the easiest way to keep tabs on your success rate is with a spreadsheet trading journal.

Trade less

It may sound glib, but an important way we can reduce our risk is to trade less. To do this, we need to monitor our results so we can hone in on the trading styles, markets, times, etc that are most profitable for us. Focus on these.

Less trading in this way, will often make more money, as well as reducing day-to-day risk.

Be aware of your stress levels

Constantly checking on trades … losing sleep … these are the tell-tale signs that you’re stressing about your trades. And that could well be a sign that you’re risking too much on your trades.

If trading is causing you stress, it’s time to reduce stakes, or to return to demo trading for a period.

Yes, trading should be a serious business, but that doesn’t mean it should be accompanied by stress and heart-ache. Most of us come to trading because we want a smarter, easier and more pleasurable way to make money – so if stress is taking that away, it’s time to reconsider your risk levels.

 

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