Strategies

Risk management in trading

risk management in trading

 

There are hundreds of articles on risk management in trading on the internet that cover various aspects of it. I’m not going to repack the content that is available out there but focus on my view on risk in trading and my strategies for risk and exposure management.

To begin with, let’s define what risk in trading actually is. For me the definition would be as follows:

Risk is the probability of losing the capital.

So, risk management involves working with probabilities and undertaking measures to reduce the probability of losing the capital. When considering risk in trading, we can speak of probabilities of losing the capital exposed during a single trade, exceeding the maximum draw-down permitted by a prop firm or our own objectives, or even blowing the entire account. The goal is to reduce the probability of negative outcomes (loss of capital) while not paralyzing our trading. We have to keep in mind that success in trading requires finding the balance between limiting risk and opening trades, thus taking risks.

“A ship is safe in harbor, but that’s not what ships are built for.”

When I was working on my own risk management strategy, I referred to insurance companies. They are dealing with risks and probabilities daily, and it is a profitable multi-billion industry, so I assumed that following their way of thinking about risk might be a good path to follow.

So, how do the insurance companies manage risk on a portfolio level, as well as on a per-client level? On a global level, they limit the exposure per client in various ways so that that they don’t make big losses on a single client/event. On a per-client level, they manage their exposure basically by:

  1. identifying client specific risks,
  2. analyzing them and deciding if the probabilities of losing capital don’t outweigh the premium,
  3. introducing measures to limit the probabilities of the risk occurrence or undertaking measures to limit them,
  4. accepting the risk, increasing the premium, or declining the client.

Why need for a risk management strategy in trading?

A commonly known truth is that the key difference between successful traders and all the rest is that the latter did not master risk management. Or worse, their emotions drive them to take (or not take) the risk! Having a good risk management strategy is as important as having a system that generates reliable entry signals. After all, it plays a similar role, but in the opposite direction – a reliable system should increase probabilities for profit whilst a risk management strategy should reduce probabilities of loss. They are like two opposites without which successful trading is not possible.

Risk management on an account and draw-down level

The general risk management breaks down to the fairly simple math and understanding what we risk. If we have an account or max. permitted draw-down of 1000 USD, then the first thing we need to make sure of is that we don’t lose that on a few trades or on a single day. Sounds like common sense, but with some brokers offering leverages of 1:500 and higher, it is not that difficult to lose everything in one or a few trades. Even with a great trading system that has an excellent win rate. The reason for this is the random distribution of winning and losing trades in any given series of trades. In other words, it is not possible to predict how many losing trades one may have in a row before a winning one occurs. This is why we have to manage our capital wisely to be able to withstand a set of consecutive losing trades and survive until series of winning trades show up. We have to be aware that the system might not work equally well under all market conditions and that we, traders (humans), have different days, so we might not be able to get into profitable trades for a day or few for any reason (see also “When not to trade – Situations which cause trading errors and mistakes”). This is where the basic math comes in.

The conventional wisdom says that one should not risk more than 2% of the account value in a single trade. For a 1000 USD account, that would be 20 USD. This should allow for a series of fifty trades, which is enough to generate profit with a decent system, even if there is an extreme series of consecutive losing trades.

While that might sound good, and a 2% loss on a trade does not seem much, five losing trades in a row will add up to 10% of the account value. Therefore, I prefer to go more conservative and not risk more than 0.5% of the account value on a single trade. I add to that profits accumulated from previous winning trades, so this way, I can scale up the position’s size significantly while maintaining such a conservative approach. But that’s a story for another article.

Daily risk management

While setting the max. permitted loss per trade to protect the account is a good start, it is not enough. Anyone who has experienced a trading trance will confirm that. Trading trance is a situation when a trader puts on trades in some state of trance, trying to take “revenge” on the market or playback the losses, while not seeing that the only result of that is producing more losses. This way, while maintaining the max. risk per trade, a trader can damage the account significantly (10 trades x conventional wisdom 2% = 20% of the account value!).

If trading trance sounds extreme, overtrading is a similar phenomenon, and probably every trader experiences it at some point.

Overtrading is the mismatch between one’s profit expectations and market volatility.
Dr. Brett Steenbarger (after Babypips)

In other words, overtrading is an attempt to squeeze out money from the market in a situation in which there are no conditions for earning them. The market might be going sideways, or there might be political tensions or unexpected news that throw the price all over the place in a chaotic manner. The reason does not matter. If something does not work, and we are not able to make money with our system, it is not worth to continue trying. To avoid the accumulation of losses, I’ve set a daily loss limit that equals the max. permitted loss of 4 losing trades (4 x 0.5% = 2% of the account value). If I make a winning trade that covers losses, I allow myself to consider resetting the counter.

Risk management on a single trade level

Pre-trade considerations

Identification of known risks before entering a trade is not difficult. Checking the news and trading calendar for major data announcements should be part of every trader’s morning routine. While we don’t have control over the news and the market’s behavior after that, we can limit the risk by either not trading, limiting the position size, or entering a trade using a separate system for volatile market conditions. No matter which path one chooses, anything is better than being caught by surprise by a big and rapid market move against open positions.

Analyzing what happened on the market on the day is also important. If I have a valid signal, but I see that the market has already moved significantly in the same direction as my planned trade, and on top of that, the price is in a supply/demand zone on a higher timeframe, I might reconsider the trade and look if the profit potential is worth the risk. Or maybe it is better to wait for the market to retrace and get in after another signal?

If the market is flat, there is no space for placing trades. An 18p price range between Sydney open and London close, as seen on the screenshot below, definitely meets the condition of a flat market. If the price did not break out from such tiny range both during London open and New York open, then there is a high probability that the market does not know where to go and does not even want to go anywhere. For me, in such conditions, it simply does not make sense to take the risk and enter any trade. I’d rather wait for the market to break out from the range first and then decide how to join the move. However, if the breakout does not happen, then I simply skip the day.

EURUSD ranging in 18p range
18p price range between Sydney open and London close

Last but not least, the way we enter a trade might also reduce our risk. For example, one of the systems I use requires me to enter a trade when the next candle after the entry signal opens. Instead of entering mechanically, I enter via a pending order placed 1-2 pips away from the candle’s opening price. That gives me an additional security buffer in case other strategies or trading algorithms would trigger a move in the opposite direction to my trade. This does not change much in terms of my trade, but it limits the number of bad entries by some 30%…

Trade management

The trade was opened based on a valid signal. The odds of earning money on this trade at this very point in time seem to be higher than 50%.

There are three possible scenarios how the situation will unfold:

  1. the price will move in the direction of the TP,
  2. the price will move in the direction of the SL,
  3. the price will hover around the entry.

In the systems I use, I expect the price to confirm that the entry is correct by a firm move in the direction of my TP within a max. 3 bars. If that happens, I can move my SL to break even (a few points in profit to cover the broker’s commission), and I’m out of risk. No matter what happens next, I will not lose any money on that trade. Whatever the previous Risk-Reward ratio was, it is not valid anymore since my risk is zero (which makes reward unlimited 🙂 ).

If the price moves in the direction of the SL or is hovering around the entry for longer than 3-4 bars, I want to reconsider the trade. The price did not move in the direction I expected, so either the signal was false, or there was not enough volatility to move the trade further in the direction of my TP, or my perception of the signal and the market led me to the wrong conclusions. Alternatively, something else happened in the market that changed the overall conditions. From my point of view, in such a situation, the risk is growing exponentially, and the probability of success is decreasing. The trade did not play out as a winning trade usually does in the system I use, so in this case, I consider the odds for success to be below 50% now. Consequently, the risk is much higher for me than at the point in time when the trade was opened, although the Risk-Reward ratio for this trade did not change. I have to decide what to do next:

  • keep the trade (and for how long),
  • move my TP to break even (risking that the price will still hit the SL – terrible Risk-Reward ratio),
  • move SL closer to the price to reduce the amount of money at risk,
  • or close the trade with a smaller loss manually at the current price.

In most cases, I want to get out of such trade ASAP since it did not play out as expected. Even if, in the end, it would end in profit, I don’t want such trade since the risk of losing money is too high.

Working with losses and draw-down management

Part of each risk management strategy should be a plan what to do with trades that are clear losers. The most popular strategy is to take the loss and move on. However, this is not the only option out there, since there are at least a few effective ways of recovering a losing trade. Using hedging as an alternative to a hard stop-loss might be a starting point for bad trade recovery. I covered the differences between hard stop-loss and hedging in a separate article “Hedging in forex”. Another strategy could involve averaging the entry price while it moves against the trade. It does not guarantee success, but it can be a very powerful option, especially for supply/demand traders and counter-trend traders.

All those strategies have one thing in common – they require taking on more risk to eliminate the loss. If used, trade recovery strategies should be a part of our trading plan. Their implementation requires skills and discipline (remember you might be already potentially stressed and have bad emotions because the trade is in red). If you don’t have a plan or discipline, better just take the loss. However, with good planning and implementation, trade recovery strategies allow to get out of almost any trade at break-even. In my opinion, this is a huge edge, and it is definitely worth investing time to explore this option (rather than looking for another magical trading system with high win rate).

In addition to everything written above, I take a twenty-minute break from opening new trades after closing a losing one. The idea behind that is to get out of trading in case something is wrong. Wrong with me, my emotions, my perception, or just the market, which is undecided for any reason.

Bottomline – risk makes reward possible

One can produce a lot of rules that will limit the risk. For example, you can limit yourself to one trade a day and pick only the best trades of the best, with the best possible entry and small SL. It will reduce the risk, at least in theory. But while being picky can reduce the number of losing trades, it will also reduce the number of winning trades and reduce the global reward per week or month. In other words, while you cannot overtrade, chickening out and sitting in the comfort zone and waiting for the one great trade does not pay off either. After all, we trade to earn money, and putting money at risk is the only way we can do that.