What is Risk Management? Well switch the words. It's the management of risk.
So, risk is a broad term in trading there are many subcategories to this. What I generally think of when considering risk is
- Risk Per Trade
- Maximum Exposure
- Trade Management
- Correlations
- Losing Streaks
- Winning Streaks
Risk Per Trade
Risk Per Trade is an important one. You have to have a fixed risk percent for every trade or else you will not succeed. This is the secret; you need consistent bet sizes and consistent execution of your positive edge to come out on top over the long run.
Probabilities only begin to work after large sample sizes for example
If you have an edge that works 50% of the time and your Risk/Reward that you go for is 2:1 so for every ONE you risk you aim to make TWO.
You have to risk the exact same amount every time e.g. 1% of your capital or you will destroy your edge. Sporadic bet sizing is what causes most traders to blow up! They go off feeling, hope, greed or fear...
There is NO WAY OF KNOWING THE OUTCOME IN THE SHORT TERM
In the short term all trades are random but once you have a larger sample size that is when the edge starts to work. For example
After 100 trades you are more likely to get 50 winners and 50 losers
This is how the Law of Large Numbers/Probabilities work
So, stick with the same risk! And also, just as important is choosing the risk per cent you feel most comfortable with. Make sure it's an amount that if you lose you will not be in emotional turmoil all day. The key to trading is to feel comfortable and trade in a calm state. You cannot do this if you are risking 10% of your net worth on every trade.
The simple formula is this:
Risk the same small amount in Favour of gaining much more than what you risked!
Maximum Exposure
This is an important metric to know and more psychologically important. What is the total amount of risk in total you feel comfortable risking at any one time. 6%? 10%? or even 20%?
This is something you need to consider because knowing what the right exposure for you will help you with not worrying and if the worst-case scenario happened of losing all your trades at once, make sure it's not an amount that would devastate you.
Trade Management and Trader Regret
Next up is the actual management of your trades. How much do you win when you are right? And how much do lose when you are wrong?
There are many methods of trade management but understanding which methods suit your personality is vital
Knowing your Psychological Profile and using Trade Management
An important step to creating your trading plan is knowing your psychological profile and implementing the best practices for you. Knowing that you will have no regrets after taking the trade is what will help you build confidence going forward.
Having the right trade management to reduce regret is crucial.
In this module I will be going over different types of trader profiles and what is the best types of management.
Trader A
All or Nothing Trader
This type of trader wants the whole move and cannot stand taking small profits in relation to the bigger move. They would rather catch the whole move or nothing
Trader B
Can’t Bear Not To Gain Trader
This type of trader cannot bear to see their trade go into profit and then come back with nothing to show
Trader C
A Mixture Of Both Trader A & B.
They are happy with small profits if it doesn’t work fully but also comfortable to risk some to capture the whole move.
Trader A
All or Nothing Trader- Would be best to use a trailing stop loss
Trader B
It's better to have partial profits early
Trader C
A mixture of partial profits early on and leave the rest to
trail to catch more of the move
So, knowing what type of trader you are. is an essential part of the process.
You need to sit down and ask yourself what kind of personality you have and what process would fit you best. The main thing to think off is how well do you handle draw downs. If you want smaller DD, then shorter targets and partial profits is best. But if you have more tolerance for a DD and want more gains then a trailing method may suit best. Once you know the management that feels most in tuned to who you are then you can begin to move forward. Firstly, though you must go out and get testing the management styles and prove it works in the long-term.
Correlations
Now this one part of risk management I don't hear much about but can have a huge impact on your bottom line. Will your strategy be allowed to trade correlated pairs or will you stay diversified and trade only instruments that are uncorrelated.
Having the latter implemented is a much safer option as you have hugely mitigated the risk of over exposure. And the potential for huge losses.
But this is up to you. If you have a system, were you trade correlated markets then that is fine, but the main thing is to be consistent with it or again a positive edge will erode from the inconsistency
Losing Streaks & Winning Streaks
So, another vital component of a trading plan and managing risk is knowing when to reduce your risk after losing streaks and winning streaks.
This is psychologically important as well
If you have tested your system and it has a historic drawdown of, say 7% you can expect after 4 losses in a row that you are nearing the expected drawdown amount so at this point it may be wise to reduce your risk in half to prevent the full 7% DD amount.
This is one way to make logical decision for reducing risk. But
on the other hand, knowing yourself psychologically is just another way to
implement the rule if you know after 4 losses that you more affected or if you are just out of sync and
this may make your decision-making process be put at risk then having a reduced
risk amount after again let's say 4 losses may be a good way to stabilize your psyche
