Risk Management

Jun 29, 2020
11 min read

Updated: Jul 3, 2020

To be a successful trader, learn risk management rules & firmly implement them.

Disclaimer: content is summarised from Part 9 (Chapter 48 - 52) of 'The New Trading for a Living: Psychology, Discipline, Trading Tools and Systems, Risk Control, Trade Management' by Alexander Elder

Regardless of good systems in place, trades will be lost, even a series of them. Hence, risk control is essential to every trading system. Inability to manage losses is one of the worst pitfalls in trading. It is a general human tendency to take profits quickly but wait for losing trades to come back to even.

1. Emotions & Probabilities

Emotional storms arise from making / losing money. "Successful trading should be a little bit boring." Long hours each day sifting market data, calculating risks & maintaining records. Beginners & gamblers get a full load of entertainment, but pay for it with losses.

Another emotional mistake is counting money in open trades which interferes with decision making. Pros focus on managing trades & count money only after trades are closed / after an accounting period like a month. It took Elder years to break the destructive habit of counting money in open trades. Count ticks, but stop your mind from converting them into dollars.

Another key point: pros do not get worked up about wins / losses in a single trade. Trader should care only about having a method with a positive expectation & work on being profitable.

Goal of a successful pro in any field is to reach personal best. Concentrate on trading right & money will come later.

Why Johnny Cannot Sell

Survival & success depends on willingness to cut losses before it is too late. This is opposite to how beginners hang on hoping for reversals (illogical; wishful thinking). Most losers respond to the same stimuli. Intellectual demands of trading are modest, but emotional demands are immense. Roy Shapiro, a psychologist suggests when we "buy" positions, the endowment effect causes us to have an attachment to the position hence Johnny does not sell, even when position losses ground. Upon purchase, critical judgment weakens & hope ascends to govern the decision process. Emotional traders crave certain gains, turn down profitable wagers that involve uncertainty & go into risky gambles to postpone taking losses. Irrational behaviour increases under pressure. Prof. Kahneman suggests that main cause of money-seeking is that money is a proxy for points on a scale of self-regard & achievement. It is all in our heads.

Review of trading records usually shows that worst damage is done by a few large losses / a long string of losses, while trying to trade out of a hole. Good money management keeps us out of that hole.

Probability & Innumeracy

Innumeracy is inability to count / understand basic notions of probability which is a fatal weakness for traders. Counting skills can be picked up from basic books & sharpened with practice. Develop a grasp of basic mathematical & logical concepts involved in trading.

“If signals A & B are present, outcome C will occur” does not hold up in the markets.

Mathematical expectation is important for traders. Based on the odds, each trade has a positive expectation, aka player’s edge, or negative expectation, aka house advantage. No system for money management can beat a negative expectation over time.

A Positive Expectation

An edge lets you win more often than lose over time. In trading, edge comes from systems that deliver greater profits than losses, after slippage & commissions, over time. Best trading systems are simple & robust. More complex systems have higher risk that some of its components will break. Traders love to optimise systems with past data however, markets change & indicator parameters nailing trends last month are unlikely to nail them a month from now. A robust system holds up well to market changes & beats a heavily optimised system in real trading. With a good system do not tinker with it unless you are making a new system. Next, set rules for money management. Money management will help you exploit a good system, but cannot rescue a bad one.

Businessman’s Risk or Loss

Analyse markets to identify trends. Future is fundamentally unknowable hence, do not grow overconfident. With buying, we expect a rally, but it is entirely possible that an unforeseen event flips the market. Actions in response to surprises will define you as a trader.

A pro manages trades, accepting a “businessman’s risk.” This means amount risked exposes him to only a minor equity drop. A loss may threaten an account’s health & even survival. Draw a clear line between a businessman’s risk & a loss. That border is defined by fraction of account trader puts at risk in a trade. Following risk management rules below means you accept only a normal businessman’s risk. Violating a well-defined red line will expose you to dangerous losses. Market seduces traders into breaking their rules.

Elder recalls a presenter with nearly a billion in his fund who designed a trading system but couldn’t trade it as it required a min. of $200,000, which he did not have back then. He had to ask for money from others & stick to his system. "It would have been unconscionable to deviate from the system I told them I would follow. My poverty worked for me.” Poverty & integrity.

2. 2 Main Rules of Risk Control

Having 2 safety nets is better than just 1 safety net. Even best planned trades can go awry due to randomness of markets. You can only control risk. Do so by managing size of trades & placement of stops. Keep the inevitable losses small. A single terrible loss / short string of bad losses does the most damage. Follow risk management rules to cut losses before they snowball. 2 pillars of money management are 2% & 6% Rules. 2% Rule saves your account from huge single losses & 6% Rule from series of losses.

2 Worst Mistakes

1. Not using stops: Trading without stops gives exposure to unlimited losses. Place stops neither too far nor too close. You have to know your max. level of risk.

2. Trades that are too large for account’s size (overtrading): This is done out of ignorance & greed. There is a simple math rule giving you max. size for every trade below

3. 2% Rule

A disastrous 25% loss to a beginner means he would have to generate a 33% return to come back to even, which is improbable. Avoid this with the 2% Rule. Losses are limited to a manageable size; a normal businessman’s risk. 2% Rule prohibits risking more than 2% of account equity on any single trade.

E.g. $50,000 in account, maximum risk on any trade is $1,000. Risk is based on distance from entry to stop. Buy a stock for $40 & stop at $38, means risk of $2 per share. Hence, max. of 500 shares.

A good trading system gives an edge in the long run, but outcome of any single trade is close to a toss-up. Stops prevent negative trades from damaging account. Technical analysis can help you decide where to place stops, limiting loss per share.

Rule applies only to money in trading account. Newbies with small accounts often object that this number is too low. Pros often say 2% is too high. You wouldn’t want to lose 2% of a million dollars on a single trade in one day. Good traders tend to stay well below the 2% limit (0.5-1%). Hence, try to risk less than 2%; it is the max. level.

The Iron Triangle of Risk Control

Trade size is formula based. Use 2% Rule to make rational decisions on max. no. of shares you may buy / sell short. With a tiny account, you may trade max. permitted no. of shares each time. As account grows bigger, vary size of trades: e.g. a third of max. for regular trades, two thirds for strong trades, & full amount for exceptional trades. Iron Triangle of risk control will set max. no. of shares you may trade.

Create the Iron Triangle in 3 steps:

A. Max. dollar risk for trade (max. 2% of your account)

B. Distance, in dollars, from planned entry to stop; max. risk per share

C. Divide A by B for max. no. of shares you may trade.

2% Rule in Futures Markets

Applying Iron Triangle of risk control to e-mini futures:

A. $50k account, 2% Rule limits risk on any trade to $1,000. If conservative, risk only 1%; $500.

B. Sell short contract at 1810, with a profit target at 1790 & a stop at 1816. Risking 6 points, & since one point in e-minis is worth $50, total risk is $300 (plus commissions & possible slippage).

C. Divide A by B for max. size trade. If max. risk is $500 trade 1 contract, if $1,000 trade 3.

Futures markets are more deadly than stocks not just due to special complexity like some specific angles but because of paper-thin margins. Though enormous leverage is offered; ability to trade large positions on a 5% margin; succeed in futures only with sensible risk control, using 2% Rule.

Beginners jump into trades without risk management. Intermediate-level traders focus on market analysis. Pros dedicate a massive proportion (even a third) of time to risk control.

If you cannot afford to trade a certain market, download its data, do your homework & paper trade to prepare (should account grow big enough / market grow quiet enough).

Daily charts with 13- & 26-day EMAs & Autoenvelopes. Impulse system & MACD-H 12-26-9. (Charts by Tradestation)

E.g. buying silver at right edge of chart. Prices have traced a double bottom with a false downside breakout. MACD-H traced a bullish divergence. Impulse system has turned blue, permitting buying. Nearby futures contract trades at $21.415 a few min before close.

Profit target is near $23, halfway from EMA to upper channel line. Stop is at $20.60, level of latest low. Risk $0.815/oz while trying to make $1.585/oz; a 2:1 reward/risk ratio.

However, $0.815/oz risk per contract means $4,075 total risk, since 1 contract = 5,000 oz of silver. Max. risk is $1,000 thus, buy a single mini-contract which covers 1,000 oz of silver (risk of $815).

E.g. buying wheat at right edge of chart. Technical picture looks similar: double bottom with a bullish divergence of MACD-Lines & MACD-H. Impulse system has turned blue, permitting buying. Shortly before close, prices are near 658 cents.

Enter there, with target near 680 cents. Stop is at 652 cents. Risk 10 cents/bu, while trying to make 22 cents/bu; reward/risk ratio of 2:1.

10 cent risk per contract means $500 total risk, since contract covers 5,000 bushels of wheat. Max. risk is $1,000. If you are very bullish, you may buy 2 contracts.

When trading futures, technical pictures of different markets may look similar, but base decisions to trade on money management rules.

4. 6% Rule

6% Rule saves you from a string of losses. Most would start pushing harder if in trouble; losing traders take on bigger positions, trying to trade out of a hole. A better response to a losing streak is to step aside & take time off to think. 6% Rule prohibits opening of new trades for rest of the month when sum of your losses for current month & risks in open trades reach 6% of account equity.

When in sync with the markets, taking one profit after another; that is the time to trade actively. When our systems go out of sync with the market, delivering a string of losses, step back. Take a break, continue to monitor the market & wait to get in gear with it again.

Concept of Available Risk

Before a trade, ask yourself: what would happen if all trades suddenly turned against you? With 2% Rule to set stops & trade sizes; 6% Rule to limit max. total loss.

1. Add up all losses taken this month.

2. Add up risks on all open trades. Dollar risk of open position is distance from entry to current stop, multiplied by trade size. E.g. bought 200 shares for $50, with a stop at $48.50, risking $1.50 per share. Open risk is $300.

3. If sum of (1) & (2) comes to 6% of account equity at beginning of the month, do not take on new trades until end of the month / until open trades move in your favour, allowing you to raise your stops.

6% Rule changes the question “do I have enough money for this trade?” to a more relevant "do I have enough risk available for this trade?” Limit of risking no more than 6% of account equity in any given month keeps total risk under control, ensuring long-term survival.

If 6% Rule prohibits new trades, continue to track stocks you are interested in. If near the 6% limit & there is a very attractive trade, either take profits on open trades to free up available risk OR tighten some protective stops, reducing open risk. Ensure that you do not make your stops too tight.

E.g. trader risks 2% of account equity on any given trade.

1. At end of the month, a trader has $50,000, with no open positions. Max. risk levels for month ahead; 2% / $1,000 per trade & 6% / $3,000 for the account.

2. Days later there is attractive stock A, he puts his stop & buys a position with $1,000 / 2% of equity at risk.

3. Days later he sees stock B & puts a similar trade, risking another $1,000.

4. He then sees stock C & buys it, risking another $1,000.

5. Next week he sees stock D, more attractive than A,B & C. He cannot buy it as his account is at 6% risk.

6. Days later, stock A rallies & he moves his stop above breakeven. Stock D still looks very attractive & he may buy it now as risk is at 4% of account: 2% in stock B, 2% in stock C & no risk in stock A as stop is above breakeven. Trader buys stock D, risking another 2%.

7. Days later, he sees stock E, which looks very bullish. But he cannot buy stock E.

8. Days later, stock B hits its stop. Stock E still looks attractive. But he still cannot buy as he already lost 2% on stock B & has 4% risk in C & D.

3 open trades is not a lot of diversification. To make more trades, set risk per trade at less than 2%. E.g. 1% risk per trade, means up to six open positions. In trading a large account, Elder uses 6% Rule but tightens 2% Rule to well under 1%.

6% Rule allows you to increase trading size when on a winning streak & stops you early in a losing streak. When markets move in your favour, you can move stops to breakeven for more available risk for new trades. If positions start going against you & hit stops, quickly stop trading & start fresh next month.

2% Rule & 6% Rule gives guidelines for pyramiding; adding to winning positions. Many traders go through emotional swings; elated at highs & gloomy at lows. It is better to invest energy in risk control instead.

5. A Comeback from a Drawdown

Higher risk levels impairs ability to perform. Beginners make money on small trade, jack up trade sizes & start losing. Increased risk on bigger positions makes them less nimble.

Start small, increase size slowly, but drop it fast in case of trouble. Train yourself to accept risks slowly & in well-defined steps. Depending on how actively you trade, those steps can be measured in weeks / months. Be profitable during 2 units of time before increasing risk size. If money is lost during 1 unit of time, decrease risk size. This is especially useful those who want to return to trading after a bad drawdown.

Unscrupulous brokers promote overtrading (trades that are too big for account) to generate commissions. Successful traders survive & prosper due to discipline.

A Trading Manager

Young private traders perform no better than older ones. When successful institutional traders go solo, most of them lose money despite using leasing the same gear, trading the same system & staying in touch with their contacts. They leave behind the manager, who ensures discipline & risk control. Manager sets max. risk per trade, max. monthly drawdown, gets rid of impulsive traders, breaks traders’ losing streaks by stopping them from trading if they reach monthly loss limit, enforces discipline that saves traders from disastrous losses. Social pressure of co-workers who actively trade creates incentive not to lose. Firms operate from huge capital bases & risk limits are much higher in dollar terms but tiny in % terms. A private trader can break 2% Rule & nobody will know.

People who leave institutions know how to trade, but their discipline is often external. Private traders have no managers. You need to become your own manager. Utilise the 2% & 6% Rules.