One of the keys to becoming a successful trader is to understand how to manage risk effectively. Those who learn this critical skill will be able to survive and thrive for years in the market. Those that don’t learn to manage risk effectively will usually end up ruined or at least severely burnt.
1) Determine your total allowed trade size.
The first step in trading risk management is to determine how much money you can allocate to each trade. Many books and investing professionals recommend allocating a maximum of 2% of your total trading account size to any individual trade. This number is somewhat arbitrary and can vary depending on a number of factors, but as a general rule it is worth keeping this number in mind. Sticking to 2% of your total trading account on any one trade will make sure that even a string of losses won’t bring you down to your knees.
Another figure to think of is the total amount of your net worth you want to have at risk on trades at any one point in time. Most opinion leaders seem to have reached a consensus of a figure of 10%.
Both the figures of the individual trade risk and the overall portfolio risk may vary from person to person.
2) Determine your stop-loss before executing the trade
The stop loss may be either a pre-determined order or a mental stop loss. Regardless, this must be a set in stone concrete figure.
In order to determine the stop loss level you should first work out the total amount you are able to risk on the trade. This should take into account round-trip commissions and slippage.
For example, with an account size of $20,000 and a total trade risk of 2%, we would be willing to risk $400 on any one trade. The stop loss, however, should be set at a point determined by market dynamics and not by a dollar value. Hence, we must find a trade where our pre-determined exit point will lead to a maximum loss of $400 including all commissions.
3) Keep records and paper trade before starting out
Record keeping is essential as it allows you to keep track of your vital statistics. The key statistics traders should keep in mind is the wins ratio and the payout ratio.
Wins ratio is simply the total number of winning trades divided by the total number of losing trades. The payout ratio is the average dollar value of winning trades divided by the total average dollar value of losing trades. Of course you should also keep records of your total returns.
Once you are breaking even with paper trading then you should start trading with real money. You need to be first comfortable and confident with the particular system you choose to work with.
These are the key basic principles of trading risk management. We’ll be posting a new article soon on more advanced trading risk management techniques.
