How to use risk management to enhance your trading
Risk management is an aspect of trading that helps traders to protect their capital from massive losses helping them to survive in the market for a lengthy period. Trading can be a risky job as statistics indicate up to 90% of retail traders across the world fail! That is where risk management plays a crucial role in trading as it helps traders to avoid huge losses preventing them from blowing up their account. It is the most important thing a trader could learn.
“Don’t focus on making money; focus on protecting what you have.” Paul Tudor Jones
How to apply risk management into your trades?
1.The first and the most crucial measure of controlling your risk is to assign a fixed amount you are willing to lose per trade if the trade goes wrong. This amount ideally depends on your account size and your risk appetite. 1-2% of your total account is the preferred size.
That means you should not be losing more than 1-2% of your account in a single bad trade placed, Example- If you are starting with an account size of $10,000 you should not lose more than $200 on a single trade.
This measure would ensure that even if 10 trades go wrong in a row, you would only lose 10-20% of your account. But if you are starting with a very small account this risk percentage can go higher up to 5-10% or even more of your account as you would have an aggressive approach towards growing your account, and your risk appetite would be higher. Using this method will ensure that you would not blow your account in a couple of bad trades.
2.The second measure is always using a stop loss when trading (especially for beginners). Many new traders sell their positions too late in the hope of prices rising again but this leads to the accumulation of bigger losses. There are various methods to decide the stop-loss price in a trade few of them are-
- 1. The low of the previous candle can be used as a stop price.
- 2. You can set the stop loss according to the profit to loss ratio.
Stop-loss eliminates the emotional aspect of a trade, helping the trader to focus on the technical part of trading it also helps in preventing excessive losses and slippage in a trade. One should have a predetermined stop-loss before even entering the trade. Using a mental stop loss can prove dangerous for a beginner trader as it can cause slippage.
3.Losers average losers Never add to a trade that is going down that makes a loss huge, accept your loss and exit the trade taking a small loss. Add to your winners and let them run. Cap your losses but never cap your winners let the winners run.
A method that can be used to decrease the risk in a winning trade is to sell half of the position at the profit target and sell the remaining position eventually as the profits increase this would ensure that a winning trade won't be converted to a losing one. Even trailing stop loss could also be used.
Scaling in and out of a position is a useful technique in trading.
4.Don't swing for home runs. A major mistake when trading is the inappropriate distribution of risk on every trade, for example- A trader is having a bad day as he has experienced 3 loss-making trades in a row, now to compensate for these losses he will try to get one big winner for which he will risk more than his usual amount, this is the wrong approach towards trading.
One big loss can dent your account and wipe out your previous profits, e.g. consider 10 trades of which 9 are profitable making $100 each totaling to a profit of $900 on the 10th trade the trader decides to risk $1000 in hope of a big win and fails, in this case despite having an accuracy of 90% the trader is still making losses. Therefore one needs to stick to his plans when it comes to trading.
5.Always use a limit order. A limit order ensures that your order gets filled at a fixed rate minimizing the chance of slippage. Avoid using market orders as your orders can get filled at any rate leaving you open to heavy slippage. Even though you can get partial fills in a limit order it would still be safer than market orders.
Here a sample risk management plan-
If the account size is $10,000 your risk per trade would be 2% i.e. $200. Now suppose you want to trade a stock worth $50
- · your stop price is $45 (previous candles low).
- · you can buy 40 shares (as $5 is the distance between stop price and buying price, and 5x40=200 i.e. max risk amount ).
- · place a limit order to buy 40 shares of the stock at $50.
- · sell half the position i.e. 20 shares at profit targets and let the profit run.
We learned why risk management is so important and how to apply risk management to your trading, the five points we studied are as follows -
- 1. Assign a fixed amount you are willing to lose per trade.
- 2. Always use a stop loss when trading
- 3. Don't add to your losers.
- 4. Don't risk it all on a single trade.
- 5. Always place a limit order.
These are some of the methods used to apply risk management into your trades.