THE BASIS OF RISK MANAGEMENT
How to master trading and not lose everything in the process.
Introduction
As traders, our job is to take the best trades we can, and as a byproduct, extract more money from the market than we donate. We will never know what the market is going to do, but we can control when to participate in the market and how much we risk when we do it.
When to participate is decided based on technical analysis.
How much we risk is decided based on risk management.
We must understand the uncertainty and unchanging nature of the market and be responsible for the things that we can control.
RISK PER TRADE
The first thing we can control when we have exposure to the market is how much percentage of the account we risk on each trade.
The standard is a range between 1-5%.
1% / It’s counterproductive unless you trade with big size.
2-3% / The most optimal option for the average trader.
5-10% / To grow small accounts if you have experience.
Choose the % you want to risk per trade in such a way that you truly accept the risk.
How to calculate it?
i.e. On a $10,000 trading account you want to risk 3%:
(Total equity x Risk %) = Risk per trade
[Express percentage as a decimal, 3% = 0.03]
($10,000 x 0.03) = $300
Note
That $300 is not the amount that we will use to enter the trade, $300 is the amount that we are willing to lose on a trade if we are stopped out.
Risk per trade = The total % of the account that the trader is willing to lose in a trade if it is stopped out.
The importance of always risking a fixed amount
Under the false belief that we could predict what will happen in the market, our brain will drive us to risk less on the trades we think will be less likely to work out and to risk more on the trades we think will succeed. Following this impulse is wrong.
Trying to change the amount you risk per trade based on the probabilities you "think" the trade has to succeed or fail usually has a negative impact on your performance in the long term.
Just because this trade looks like a "no-brainer" you shouldn't risk 4%, and on the other one that looks like it won't work risk 1%, because in the not so distant future, you will find yourself losing huge amounts on losing trades and winning very little on winning trades.
When you decide the % you want to risk per trade, stick to it.
Fixed risk
3% of a $10,000 account is $300 but, as you execute trades the account balance will change and that will cause the 3% result to be a different number. For example, if our account balance drops from $10,000 to $8,000, the 3% of the account will no longer be $300, but $240.
What to do then? We have two options.
Always risk the same fixed %
Every time we are going to execute a trade, as the trading account balance will be different, we recalculate how much the % is equivalent to.
If the trading account balance changes to $5,000, 3% will be $150.
If the trading account balance changes to $2,000, 3% will be $60.
If the trading account balance changes to $12,000, 3% will be $360.
This method can be useful for inexperienced traders.
Always risk the same fixed amount
This is the most common method. It consists of calculating the % of the trading account we want to risk per trade, let's say 3% of a $10,000 account ($300), and risk that amount ($300) on each trade even when the account balance changes.
Rule exceptions
There are some scenarios in which modifying the fixed amount we risk per trade could be beneficial for us.
Periodic losing streaks are normal and completely unavoidable, but as they occur we can learn from them and try to reduce their duration, frequency and the potential damage they can cause to our trading account.
One of the most useful tools to reduce the damage a losing streak can cause to our trading account is to reduce the amount we risk per trade while we are going through one, then return to the default amount once it ends and we regain confidence.
POSITION SIZE
The heart of risk management.
We have already decided how much we are going to risk per trade, but how am I supposed to risk the same fixed amount in a 5-minute scalp as in a 15-day swing trade?
We are going to learn to adjust the size of the position, that is, the amount that we are going to buy/sell in each trade to always risk the same fixed amount, regardless of the distance the Stop Loss (invalidation) is.
If this concept is new to you it may seem a bit complex, but over time you will see how simple and intuitive it is.
How to calculate
i.e. A trader with a $10,000 trading account wants to execute 2 different trades:
Swing trade
- Risk per trade 3% ($300)
- 2-6 weeks trade duration (long-term)
- Stop Loss is 9.46% away from his entry.
Scalp trade
- Risk per trade 3% ($300)
- 1-8 hours trade duration (short-term)
- Stop Loss is 0.86% away from his entry.
Even though the trades are very different, in both he wants to risk the same, 3% of the account ($300). So, the only thing we have to do is to adjust the position size of each trade, i.e. adjust the amount of contrats he has to buy/sell on each trade.
Formula: (Risk per trade) ÷ Distance to Stop Loss from Entry.
Swing Trade
($300) ÷ 0.0946 = 3,171 contracts
That means he has to buy $3,171 worth of ‘X’ coin to risk 3% of his acc with a 9.46% SL
Scalp Trade
($300) ÷ 0.0086 = 34,883 contracts
That means he has to buy $34,883 worth of ‘X’ coin to risk 3% of his acc with a 0.86% SL
Although the timeframe and invalidation distance are very different, we can risk the same amount in both trades by simply changing the size of the trade.
RISK:REWARD CORE CONCEPTS
The risk management language
Although the market generates a new opportunity every minute, every one you take costs you money and time.
So, to be able to decide which one to take and which not to take, you must learn to look at every opportunity you see on the chart from a risk:reward perspective.
To achieve this, start by asking yourself these 2 questions when you identify a new one.
If I take it, how much would I risk and what would be the potential profit?
Knowing that, is this opportunity worth the risk?
If the potential profit is bigger than the amount you risk, you are on the right track, but since there are more factors that will help you decide which opportunities to take and which not to take, let's start at the beginning. What is 1R?
Risk Reward Language
1R is the main unit of measurement in R:R language, and it’s used by traders to measure their profit/loss in any given position.
1R = (The fixed amount we risk on each trade)
Let’s take one of the above examples (A trader with a $10,000 trading account that wants to risk 3% [$300] on each trade).
If he risks $300 per trade (If he get stopped out he will lose $300), then 1R = $300.
Lose 1R = Lose the fixed amount he risked. (Loss = $300)
Win 1R = Win the same amount he risked. (Win = $300)
Win 2R = Win two times the amount he risked. (Win = $600)
Win 3R = Win three times the amount he risked. (Win = $900)
1R is different for each trader and depend on how much they decided to risk per trade.
- Trader A: Risk 100$ on each trade, then 1R = $100 for him.
- Trader B: Risk 500$ on each trade, then 1R = $500 for him.
Risk:Reward Setup Anatomy
Every trading idea we materialize into an actionable setup is made up of 3 main points.
Entry - Point at which you open the trade.
Stop Loss - Point at which you will exit the trade for a loss if your idea is wrong.
Take Profit - Point at which you will exit the trade for a gain if your idea is right.
In theory, we plan at what points we will enter and exit the position.
In practice, sometimes we follow the plan and close the trade at the predefined Stop Loss or Take Profit, other times the market force us to forget our plan and close the trade in zones that are not the predefined ones.
Let’s dissect a trading setup in order to fully understand it’s anatomy and how it can affect our performance to close our trade in areas that are not the predefined ones.
In addition to the three pre-defined points by a trader (Entry, Stop Loss, Take Profit) we find the red zone, no man's land, and take profit zone, and we can divide them into 2 categories. Zones in which we must take no action and zones in which it is optional to take action.
Red Zone
Situated between entry point and stop loss.
Seeing the price below our entry point for a prolonged period of time can trigger the emotional reaction of cutting the trade to stop feeling pain - but since we decided at what point our idea would be invalidated (Stop Loss) before entering a trade - exiting earlier simply does not make sense.
Why are you cutting your trade? To stop feeling pain or because your original idea is invalidated.
If you are in the habit of closing your trades before they are technically invalidated, you will lose confidence and will not let any trade develop. For that reason the red zone is an observation zone where we should not take action.
No man’s land
Situated between entry point and 1R.
Accustomed to receiving instant gratification at all times, a trade that does not go from entry to take profit in a short period of time becomes uncomfortable.
Many times we think our idea/setup is wrong just because the price has barely moved away from the entry point, so we make the emotional decision to cut it.
The trade has not been invalidated, but we cut it out of impatience.
The thing is, when we cut a trade in No man's land - below 1R - the profit is smaller than the amount we were willing to lose if we were stopped out. It may seem harmless, but if we are used to cutting trades in this zone, in the long term we will find ourselves with very small profits and big losses.
In a few cases we can cut the trade here, but we must not let it become a habit. That's why this is an area where we should not take action either.
Take Profit Zone
Situated between 1R and the predefined Take Profit point.
From 1R we have green light to start taking profits without negatively affecting our long term performance. (1R is the minimum take profit zone because if you cut the trade here, your profit = the amount you risk per trade).
For this reason taking profit in this zone is optional.
RISK:REWARD SYSTEM
Risk:Reward core concepts applied
Almost any time we look at the chart we see opportunities available. We must choose wisely which opportunities are worth risking our money on.
Through technical analysis, filter the most unlikely scenarios and focus on the scenarios that have more probabilities to happen.
Analyze and plan how you would execute those scenarios to transform a trade idea into an actionable setup.
Then, under risk management decide if these setup ideas are worth taking or not.
To turn an idea into an actionable setup we must define the point at which we will enter the position (Entry), the point where our idea is invalidated (Stop Loss) and the area where we will take profits if our idea was correct (Take Profit).
To filtering which setup ideas are worth taking we must find a positive balance between risk:reward, time cost and probability.
Risk:Reward
After a strong move up, we are confident there will be another leg up but because we are entering so high, the invalidation point is so far away from the entry. As a result we have a 1:1R setup, in which if it works out, we will gain the same amount that we are willing to lose.
Even with a high probability, is it worth taking the risk for such a ‘small’ profit?
Time cost
Executing a 1:2R setup on the weekly chart may have a high probability of success because the Stop Loss is far away, but it may take too long to hit your take profit.
Is that profit worth all that long waiting time?
Probability
Executing a 1:8R setup on the 5-minute chart would give you a big gain in a very short time, but it has low probability of working out because the invalidation is very close.
Is it worth losing the $$$ I risk per trade in 2 minutes on a setup with low chances of succeding?
After discovering position size and Risk:Reward concepts the possibilities become practically unlimited. You can run 2R, 4R, 8R or +10R setups on either the 5 minute chart or the weekly chart, but you must find a balance in each setup you execute.
If the balance between Risk:Reward, time cost and probability is positive, it is worth executing that idea.
High | Low Probability Setups
If we identify a trading idea we want to take, we can play with the position of the stop loss to have two different actionable setups depending on our risk appetite.
Less probability of working out and bigger potential profit.
More probability of working out and smaller potential profit.
The closer the invalidation point is to our entry, the more likely we are to be stopped out.
The farther away the invalidation point is from our entry the more margin of error our idea has, making it the less likely it is that we are stopped out if our idea is correct.
Let's illustrate this with an example: ( Trader 101, [Risk $300 per trade] is very confident that a leg up is next. He has no problem choosing where to enter the trade and where to exit if he is right, but he doesn't know how much the price could deviate from his initial idea so, choosing where to put the Stop Loss is a bit complex).
Depending on his risk appetite he can take two different setups just by choosing a different invalidation point (Stop Loss).
Low Probability Setup
- Tight invalidation (-1R = -$300)
- High potential reward (+6R = $1800)
- Low probability
High Probability Setup
- Larger invalidation (-1R = -$300)
- Less potential reward (+2.5R = $750)
- High probability
It’s the same idea (Leg up), entry and take profit, but depending on his risk appetite and how confident he is in his analysis/idea, he can divide it into two different setups just by choosing 2 different invalidation points.
Which one to choose? There is no right or wrong, but this will help guide you.
Tendency to take low probability setups
If you win a 6R trade, you can lose 6 trades (-1R,-1R,-1R,-1R,-1R,-1R) to break even.
You can be wrong more often but your trades are more likely to fail because the invalidation is closer, your idea has less margin of error.
Tendency to take high probability setups
If you win a 2R trade, you can lose two trades (-1R,-1R) to get back to break even.
You can be wrong less often but your trades are more likely to be winners (because the invalidation point is farther away).
Long term Profitability & Win rate
It is after knowing all of the above that you realize that not everything is black and white and that there is no one right way to trade.
Every trader has his own way of playing it.
Some are wrong many times but when they win, they win big.
Others win less but they are right more often.
And both can be profitable.
Here is a table that illustrates this perfectly.
In an account with 1000 trades;
Taking 1:1R setups, you will need 50% winrate (500 trades win, 500 trades loss) to be breakeven
Taking 2:1R setups, you will need 40% winrate (400 trades win, 600 trades loss) to be profitable
Taking 3:1R setups, you will need 30% winrate (300 trades win, 700 trades loss) to be profitable
Taking 4:1R setups, you will need 20% winrate (200 trades win, 800 trades loss) to be breakeven
That said, you do not need to always take a specific type of setups (1:2R 1:5R, etc..). As in other aspects of trading and life, you must learn to adapt to each situation and take the best possible trades you can.
FINAL NOTE
The knowledge I have just shared took me several years and thousands of trades to learn.
These risk management concepts are 90%, and technical analysis skills are 10%.
Most people who master these concepts will only teach it to you in exchange for money – but you know what? Fuck it, knowledge should be free – that's the right thing to do.
So take it, it's yours.
If you want to show gratitude anyway, you can use my Bybit link.
With love, Inmortal.
Many thanks man! it's all concepts I know but it's nice to read in a well presented and organized way
So clear. Thanks Inmortal.
Is there a tool on Trading View that i can use to calculate position size?