What is Risk Management in Trading

by | Mar 15, 2022

risk management trading

Trading, especially in shorter time frames, can be quite volatile depending on the asset class you are investing in. Traders who are able to make a living using price action (the up and down movement of price) must be able to manage their risks. As with any speculative market, understanding your downside and protecting your capital is essential to staying profitable and avoiding potential financial catastrophe. 

We have all heard the horror stories of people losing their entire savings or even worse owing more than they have. Asking friends or family to bail you out, or taking out high interest loans to pay back debts can destroy everything you have worked so hard for in the blink of an eye. This is why risk management is so important.

Risk management helps minimize your loss on any given trade that moves away from your target.

Traders, new and old, all intend to make money and win trades. Reality check, no one wins 100% of the time. Losses are part of trading, but as long as you minimize losses and maximize wins, you can ‘live to trade another day’ and hopefully build up the value of your portfolio along the way.

Trading Truth:

One bad mismanaged trade without your risk mitigated can wipe out 10 winning trades (that cost you many hours of research, stress, and time away from your family). Not ideal, nor does it preserve your capital for the days when trading may be easier, say during a clear up or down trend.

How to Plan Your Trades Properly

Step one, use Technical Analysis or other means of charting to determine your plan.

  • Do you believe the price is going up or down?
  • At what point is your idea proven to be wrong?
  • What can you afford to lose on this trade?
  • What profit levels will make sense and make the Risk to Reward (R/R) worthy of entering the trade in the first place?

Setting Your Stop-Loss

A Stop-Loss is a type of order that is executed at a set price that will automatically close your position if it is clearly going the wrong way based on your idea and predetermined risk appetite.

For example, if you say to yourself that you are willing to risk losing $30 in order to potentially gain $300, then you would set your Stop-Loss at a level where the loss is $30, therefore providing clear invalidation to your idea, vs. letting the losing trade continue to accrue loss. This way, if you are wrong, you close with minimal loss, and move on to the next idea.

Many traders make the mistake of thinking that if they hold on to their position without a stop loss in place, that it will just come back into profitability, so why set it? Markets are volatile, and there are no guarantees that your trade will eventually turn favorable. In fact it might go to 0 or even so high that your short is now deep in a negative balance.

The below is a screenshot of the the popular crypto trading platform, FTX. They have a clearly labeled area to enter in your stop-loss amount. FTX is not unique in this sense as nearly all brokerage or trading platforms offer this option.

The Bottom Line- Stop the bleeding before it gets unmanageable.

Your capital is the most important thing, so holding a negative trade too long can hinder your ability to enter more appealing trades because your money is all tied up.

Determining Your Appetite for Risk

There are many different ways to do this, but the most popular is the 1% Rule. Simply put, you should not risk more than 1% of your trading balance on any one trade.

Example: Your trading balance is $1000

Max Loss: $10 (per trade)

Seems simple enough right? But there is more to it.

Traders use Technical Analysis to chart their entry points and stop-loss points (where the idea is invalidated), and then use this info to determine how many stocks, cryptocurrencies, or futures contracts to buy to follow their determined risk tolerance.

Example below:

Here we look at a chart for a (crypto) Ren Perpetual Futures Contract on the 1hr timeframe. 

As you can see, there is a clear:

Entry Point ✅

Stop- Loss Point ✅

Exit Point ✅

Notice how the Stop- Loss price is 3.23% away from the entry price? This means that if the price travels lower than 3.23% away in the wrong direction of the entry price, then the order will automatically close and the loss will be realized. But above we said only 1% of the trading balance should be risked, so why is this 3.23%? Determining your trade idea is one thing, but using it to buy the proper position size is another. Using a trade position size calculator, this can be quite easy.

Example below:

Let’s break down the above. The starting balance is $5545, the risk percentage we are willing to lose per trade is 1% of that starting balance ($5545). We then have our trade entry points per the chart above as well as our stop- loss triggers. We can now see that the position size we should enter is 4699.15.

Position sizes are not random numbers. They should match up with your plan.

Deciding if a Trade is Worth Entering

This is quite a loaded topic, so we will just touch on the guidance. When you consider entering any trade, there should be a minimum reward to risk ratio. This means analyzing whether the reward is worth the risk. Most traders look at a minimum of 1.5 R:R, although many will tell you they only enter if R is much higher.

In most cases you should come up with a basic acceptable reward scenario taking into consideration the potential risk if your stop-loss is hit plus time commitments and the opportunity costs that suit you. 

Managing Risk- Other Things to Consider

Depending on the market you choose to trade in and your trading style, risk can vary quite a bit. For example, scalper style traders are in and out of trades quickly, some in less than 5 minutes. They are only looking for small percentage wins, which if done multiple times a day or with larger positions sizes can be significant. Also, crypto markets move very very quickly, and oftentimes swing 20%-100% within minutes. Therefore, calculating your risk should take into consideration markets, tolerance, and capital available.

Take Away:

Always Manage Your Risk. Trading is a marathon, not a sprint. The Marathon Continues…