Risk Management Strategies Every Trader Should Master
Trading without a workable risk management strategy is like driving without car insurance – you may be willing to risk going without for awhile, but it would only take one bad accident to wipe it all out. 80%* of new traders lose money in their first year due to undisciplined risk management. The key to successful trading isn’t to be able to predict the future perfectly, it’s to protect your capital and put yourself in a position to profit from favorable market movements. The traders who remain amongst us and make the good money are the ones that understand the most important thing that they can hone is risk management by applying some system to manage worse case outcomes and protect their losing streaks and make the most out of winning streaks.
It doesn’t matter if you are trading the prop firm’s capital or your own funds, these are not optional. The reason prop trading have tight risk protocols, is because they understand that winning over the long run is about consistency, not luck.
The Foundation: Position Sizing
Position sizing is all about how much risk you put on a trade, and it’s one of the most important aspects of risk management. The rule of thumb is never to risk more than 1–2% of your overall account in one trade. This would mean with a $10,000 account you would never risk more than $100 – $200 on any given position. This conservative approach means even if you go through a lot of losing trades, your account isn’t going to be decimated by losses, and you will have time to recover and learn from mistakes.
Essential Risk Management Tools
- Stop-Loss Orders: Establish predefined exit levels from the beginning of any trade. This takes emotion out of loss-cutting decisions, and does not allow small losses to snowball.
- Risk-Reward Ratios: Look for trades where the potential gains are at least twice the potential losses. A 2:1 risk-reward ratio allows you to be wrong 60% of the time and still make money.
- Diversify your Portfolio: Don’t invest all your capital into similar types of instruments. Diversify risk by industries, asset classes or trade strategies to avoid over portfolio concentration.
- Max Time Loss Limits: Set a threshold for an amount of time in a day you can lose and stop trading when you reach that limit. This is in order to avoid emotional revenge trading which is one of the many reasons accounts are blown.
Advanced Risk Control Techniques
Sophisticated techniques, such as trailing stops (locking in profits as trades move in your favor), position correlation analysis (avoiding overexposure to similar assets) and volatility adjusted position sizing (reducing trade size during high volatility periods) are used by professional traders. You may want to incorporate a trading journal that not only tracks wins and losses, but also how well you adhered to your risk management rules. This data is used for pattern identification and to improve your risk control over time.
For individuals who are looking to enhance trading discipline, platforms like wemastertrade provides educational materials, trade plans and even the wisdom of the crowd generated by other users, and push traders to put these risk controls into place in the right way.
The Psychology of Risk Management
The biggest problem in risk management is not technical; it is psychological. Traders bet too much on “sure thing” trades and the pain of taking losses causes many to hold losing positions too long. Develop the fortitude to think of a trade as one of hundreds or thousands. The edge is in continual adherence to your risk management, nothing else but YOU can be on A-Game here.
Wrapping Up
Professional traders are distinguished from gamblers by their ability to master risk management. Begin by practicing simple position sizing and stop-loss strategies before advancing to more complex methods once you become more adept. Just remember: not only to avoid all losses – but to make sure that your winning trades are larger than your losing trades, and that no one trade will blow your account. As dull as it may be compared to chasing the “big win,” consistent risk management is what all successful trading careers are built on.