Using risk management when trading is paramount in order to keep your trading losses to a small amount and to help preserve your trading capital. It has often been said that risk management is one of the most crucial elements for traders to contend with. Managing trading risk is something that you can control as a trader, unlike price movement which is something that you cannot control. As such, it’s important that your risk management rules be documented in your trading plan and be followed with disciplined.
A Risk Management Plan Should Include
1) Allocation of Trading Capital – knowing how much of your total trading capital should be allocated to one particular trade. Don’t risk all of your money in trading just one financial instrument which is more like taking the gamblers approach.
2) Maximum Trade Risk – knowing the maximum loss willing to accept for a particular trade before having to close it out. This will help to ensure that small losses won’t turn into much larger ones.
Popular Ways To Manage Trading Risk
1) Stop Loss Orders
Using stop loss orders are common among traders to help protect them against losses that could either quickly or emotionally become spiraling out of control. Although setting stop losses can be a little subjective depending on the objectives and analysis of the trade, they should never be set to exceed your maximum trading risk (risk tolerance). Stop Loss “Rough” Guidelines Swing traders will usually have tighter stop losses in place compared to trend traders and position traders due to the smaller profits trying to be captured within a shorter time frame. And, day traders will definitely have tighter stop losses in place out of all the other types of trading styles. The following are “rough” guidelines as to how a fictitious trader engaging in the following trading styles might consider the amount of acceptable maximum trading risk to tolerate:
- Trend traders and Position traders may be comfortable with accepting a 5% to 10% trading loss
- Swing traders may be comfortable with accepting a 3% to 6% trading loss
- Day traders may be comfortable with accepting a 1% (or less) trading loss
Here is what one legendary trader and investor has to say about how much loss to tolerate before exiting your position –
“Cut all losses at no more than 7% or 8% below the buy point, with no exceptions, to minimize losses and to preserve gains”
– William O’Neil Founder of Investor’s Business Daily Creator of the “CANSLIM” Formula
This is definitely great risk management advice by the legendary Mr. O’Neil. However, it would be more applicable to longer-term trading styles like trend trading and position trading where possible smaller adverse price swings would automatically be accommodated in the hopes of achieving larger price moves with these types of trading styles. Setting The Stop Loss – Really Depends On You The amount of loss that you are willing to accept when placing your stop loss order really depends on you. Here are some suggestions that you may want to consider:
- Should not be more than your maximum risk tolerance
- Depends on the type of trading style
- Price fluctuations occurring within the time frame being traded
- Technical analysis (discussed below)
Technical Analysis – Insight For Setting Your Stop Loss A solid understanding of technical analysis and knowing key areas on a chart will serve as an invaluable asset to best position your stop loss order. This will help you to strike a happy balance between giving your trade enough breathing room while at the same time keeping your maximum risk tolerance rules intact. TIP: what is probably more important than just setting your stop loss to a certain fixed percentage amount is the relative “technical” location of it. Once you have decided on your stop loss for a trade, then, ask yourself – “does it sit well on a chart using your favorite principles of technical analysis?” For example:
- Is the stop loss order in a likely impact zone where it might get triggered too soon?
- Where is it in relation to support (or resistance)?
- What type of candlestick (or small cluster of) is closest to where you want to place your stop loss?
Keep In Mind If the stop loss is placed too tight, you run the risk of getting bounced out of your trade too soon. On the other hand, if the stop loss is placed too loose, you run the risk of accepting a greater loss beyond a reasonable amount from what your trading plan may suggest. Your stop loss order will automatically serve as your protective “watchdog” to get you out of harms way – even if you are away from your computer. Remember, stop loss orders are flexible and can easily be adjusted at any time to manage trading risk as well as to lock in profits during the trade.
2) “Trailing” Stop Loss Orders
This kind of order is a close cousin to the stop loss order explained above. However, unlike the stop loss order, the “trailing” stop loss order will automatically adjust itself after the stock moves in the direction as you have expected. You can set your own trailing stop loss criteria as to how far away or close you want this order to trail behind the actual stock price. If, however, the stock goes in the opposite direction as you have expected, the “trailing” stop loss order will not adjust itself to put you in a worse loss position. Caution Note: stop loss orders are subject to “GAP” risk.
ADVANCED Risk Management Strategies
Hedging Techniques Advanced risk management strategies can include hedging techniques such as using stocks, etf’s and options that can take an offsetting side to your current trading position.
Example – Hedging with Options: if you buy a stock, you can then buy an appropriate underlying put option to hedge against any potential losses of a decline in that stock’s price. In another words, if the stock price starts to fall, the appropriate put option will start to gain in value.
Tip: To reduce the cost of hedging with the underlying put option, you can partially, if not fully, offset this cost by selling an entirely different type of option against it with using a call option.
If you have a trading portfolio that is broader in nature with multiple holdings, you can find a correlated broad based index fund that closely matches your portfolio and use the appropriate options of such index fund to hedge against potential portfolio losses.
Example – Hedging with Exchange-Traded Funds (ETFs): if you own a diversified trading portfolio that you don’t want to sell if you believe that market volatility will soon be increasing, you can use a closely correlated exchange-traded fund to “short” or even use an inverse ETF fund to mange trading risk.
Summary – Risk Management When Trading
Having rules in place to manage trading risk will greatly help you to keep your trading losses to a small amount and to help preserve your most precious asset – your trading capital. This is what professional traders do religiously!