Risk management is absolutely pivotal to any trader's success whether they are just starting
out or a seasoned professional.
If you trade without a risk management strategy, you will most likely lose your entire account
at some point.
I'm Luke from disciplined trader and in this video we are going to explore the dangers
of trading without a risk management strategy, discuss what key points should be included
in a good risk management strategy and finally look at how you can make your own - Let's
get started One of the most common mistakes among new
traders is to start trading with a real account without giving any thought to the amount of
money they are risking beforehand.
They may have had some short term success trading on a demo account and now think they
feel comfortable enough to start risking their own money.
Only what they don't realise is the emotions you encounter when your actual money is on
the line are very different from those when you are just demo trading.
Lets have a look at what a typical trade may look like by a trader in this situation.
Meet Bill.
He is relatively new to trading and has spent the last two months demo trading with virtual
funds.
He had great success on his demo account and wants to replicate that success with his real
money.
"No problem!, it's going to be easy" He has a trading account of £2000 and wants
to make £200 a day from the markets so he can give up his job.
On his first day of live trading he identifies a setup to go long in the market he is watching.
He has decided that the target for the trade should be 10 points as this would line up
with a previous high.
So to reach his daily target he works out that he needs to trade at £20 per point to
make £200 on this trade.
He enters the market at £20 per point long and begins to anxiously watch the price movement.
The price moves up five points and Bill is elated.
He is already half way to his daily target.
Price holds at this level for a while and Bill starts to become agitated.
He starts thinking "I should just take the profit here!"
but then argues "ahh I'm only half way to my target, there's only five points to go,
I'll stick with it" So he stays in the trade.
The price then starts to drift down, back to break even and then to 10 points below
his entry.
Bill is now very angry with himself!
He can't believe he didn't take the profit when he had the chance.
He's convinced himself he can't take a loss on this trade now, it was in profit and he
let it slip away.
He decides "I'll close the trade when it's back to break even."
Price however starts to fall further, it's now 20 points below where he entered and still
falling.
He's now completely paralysed by what's happening.
He is furious with himself for not taking the profit when he had the chance and is desperate
for price to rise again so he can close the trade at break even.
Unfortunately for our trader though, price continues to fall and with it go our trader's
hopes of getting out of this trade without losing money.
The pain of the potential loss finally becomes too much and he closes the trade for a 40
point loss.
This equates to a £800 draw down on his £2000 account.
That's a 40% draw down on his account in just one trade!
This leaves Bill feeling broken and beaten and in a state of mind that could lead him
to make further mistakes in the market in a desperate attempt to recover his losses.
"I'm f*cked!"
Now jokes aside, that scenario may seem a little extreme to some of you but that is
how a lot of traders blow a huge proportion of their accounts if not the whole thing.
They are completely unprepared when they need to make decisions at key points during their
trades.
This almost always leads to trader's becoming annoyed with themselves as they look back
in hindsight and question why they didn't take the profit when it was available to them.
But how were they supposed to know that was as much profit as that trade was going to
make at the time!?
It's like they think My point here is that trading is not a sure
thing, it boils down to a game of probabilities.
Some of your trades will make money and some will lose money.
It's the role of your trading strategy to ensure that the trading opportunities you
identify give you an edge in the market over the long term.
However, just having a good trading strategy is not enough.
As in the scenario we just looked at, the opportunity bill identified was a good one.
It matched all his criteria set out in his trading strategy.
The trade fell down as Bill didn't quantify and manage the amount of risk he was taking
on the trade.
In actual fact, he had absolutely no idea before entering the trade what amount he was
risking.
He calculated his position size by making the profit target equal his daily target,
there was no consideration given to the amount he was risking, only what he was going to
make.
That's the reason he panicked when the price started moving against him.
So to combat this, all traders should have a well thought out risk management strategy
to complement their trading strategy.
It is the role of your risk management strategy to specify the amount of your account you
are willing to risk in certain situations.
One example of this is the amount of your account you are willing to risk on a particular
trade setup.
So for example, Bill may decide that he only wants to risk 2% of his trading account on
a trade setup.
His trading strategy should specify how he is going to exit that trade, lets say in this
example the trade setup we are looking at has a fixed stop of 20 points.
We already know he has an account of £2000 so the position size he would enter the market
at would be ((£2000x0.02)/20=£2) £2 per point.
Then if this trade loses and Bill's stop level is hit, he loses £40 of his account which
is the 2% his risk management strategy specified he could risk.
This minimises the likelihood of Bill's emotions causing him to make silly decisions in the
markets and losing vast amounts of his account quickly.
So what should a risk management strategy should include I hear you say?
Personally I think it should cover at least these four key areas.
1) The percentage you are willing to risk on each trade, this could be different for
different trade setups. 2) the total percentage draw down you can have in a single day before
you stop trading.
3) The total amount of risk you can have on your account at any one time.
And 4) When to increase or decrease your risk parameters depending on your account growth
or decline.
So lets look at these key points a little closer.
We have already looked at the reason for having this first point but it's worth discussing
how you actually decide what percentage to risk on each trade.
The first part of this answer in short is back testing.
If you have a strategy that you are using, you should have back tested that strategy
already Hang on hang on, I should have back tested
my strategy?
Yes But I bought it from a guy online that knows
what he's doing And?
Well it cost me a lot of money And?
Well he assures me it's profitable Your point is?
What, you think I should have still back tested it?
How the fuck do you know if it's actually profitable or not if you haven't back tested
it!
But seriously, look at you back testing and use the results to work out your trade win
rate.
Using this you can calculate how likely losing streaks will be and from this you can work
out a safe percentage of your account to risk on each trade without putting it in danger
of having a huge draw down from a losing streak.
I have made a more in-depth video on how to do this so I will leave a link to it in the
description below.
The second part of this answer is how much you actually feel comfortable risking on a
trade.
You don't want to risk so much that you become stressed while your trades progress, like
Bill in scenario earlier.
Although your back testing results may show that it is safe to risk 5% on each trade for
example, that amount may prevent you from keeping a calm and clear head during your
trades.
So reduce it to an amount you can comfortably deal
with emotionally.
The third point applies more to traders that actively trade more than one market.
If you are opening multiple trades at once it can be difficult to know how much risk
exposure is on your account.
Therefore, if you set a maximum limit for this, it forces you to think more about your
position sizes on the trades you are taking to protect your account from a big draw down
if you have a batch of losing trades across different markets for example.
The limit maybe something like 7%.
So if you are looking to open a new trade and you know you already have three trades
open each risking 2%, you know that you can only risk 1% of your account on this trade
if you are going to enter.
The last point was increasing or decreasing your risk parameters depending on your account
growth or decline.
The purpose of this point is again to help with the emotions that can destroy your account
after a run of losing trades.
If you have just gone through a losing streak of 10 trades and have risked 3% on each trade,
your account is down 30%.
Even though you may have followed all your trading rules to the dot, self-doubt and the
desperate need to make back your losses can start to creep in to your head.
So in order to build your confidence back up, it can be helpful to reduce the risk parameters
you've set.
So you may start risking only 1% on each trade and stop trading for the day after a 3% draw
down in any day.
Then when you are feeling more confident in your trading approach again, you can increase
your risk parameters back to their previous levels.
As I am sure you have worked out by now, the purpose of a risk management strategy is to
protect your account from big draw downs and to help keep the trader in a healthy mental
position so they are able to objectively assess the markets and take the correct trading opportunities.
If you want to succeed in trading, you can't take a gamblers approach otherwise your account
will only last 5 minutes.
This is not a get rich quick method, it is a long endeavor that takes a good amount of
time to master.
Think of it like training for any other qualified job, you wouldn't expect to be a qualified
doctor or pilot after studying for a couple of days or months and the same is true for
trading.
A good risk management strategy is there to make sure your account is not destroyed during
that endeavor and will ultimately stand you in good stead as you become profitable over
time.
So that wraps up this video on risk management, I really hope you have found the information
to be useful.
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I hope you all have a good week in the markets and I'll catch you in the next one.