Every trader comes to trading with the expectation to make money. But the truth is that there must be losses at some point. Losses are part of the game. What you need is to minimize your losses to protect your capital and profits, and you can only achieve that with a risk management strategy. So, what is your risk management strategy?
In trading, risk management refers to the strategy you use to protect your trading capital so that you stand a chance of making profits. It is the steps you take to minimize losses and protect profits. So, it is an ongoing process to protect your account from losses that you can’t afford. A good risk management strategy not only protects your capital but also helps you to maintain profitability.
In this post, we take a look at risk management strategy and we end the article with a backtest of the strategy.
However, before you continue reading, you might want to know we have presented hundreds of free trading strategy articles on our website. They all come with specific trading rules and backtests.
What is a risk management strategy in trading?
In trading, risk management refers to the strategy you use to protect your trading capital so that you stand a chance of making profits. It is the steps you take to minimize losses and protect profits. So, it is an ongoing process to protect your account from losses that you can’t afford.
In the words of Warren Buffet: “The first rule of the game is to protect your capital, and the second one is to never forget the first rule.” So, whether you are a professional trader or amateur, day trader or swing trader, etc, you must have a risk management strategy. However, the risk management strategies you can use will vary depending on the situation and type of trade.
List of all the risk management strategies
There are different risk management strategies. These are some of them:
- Position sizing and use of leverage: This helps to reduce account risk, as the higher the position size, the more the leverage, and the higher the risk for any given account size.
- Use of level-based stop loss: This helps limit the risk of a catastrophic loss in each trade. It is very necessary because of the possibility of a black swan event, such as the Swiss franc event in 2015.
- Use of time-based stop loss: This allows you to close out a trade that is no longer likely to work as expected.
- Use of trailing stop: This helps to lock in floating profit and prevent turning a winning trade into a loser.
- Use of profit targets: This helps to prevent turning a winning trade into a losing one
- Hedging strategies: They are used to manage risk by opening another position.
- Diversification: This involves trading different non-correlating instruments and strategies and trading on different timeframes so that when one is losing, another is making money to offset the losses.
We have practically covered all those topics in previous articles. Let’s look at them:
First, leverage might be lethal. How much leverage can your strategy tolerate before you either abandon the strategy, or even worse, you end belly up?
In our article that shows a profitable leverage trading strategy we cover exactly that. We show you how you can utilize Maximum Adverse Excursion (MAE) to your advantage:
Second, you might wish to use a stop-loss. But what does the evidence say? We have been backtesting for over two decades, and we have yet to see any positive consistency in using a stop-loss. On the contrary, most strategies perform worse with a stop loss in place. It makes sense, because it’s mostly an arbitrary setting. Instead of a stop loss we recommend several alternatives to stop loss.
Third, the above arguments about stop loss also applies to trailing stops and profit targets. A profit target in trading has not proven to work in our backtests.
Fourth, hedging strategies work. This is the best risk mitigation there is! Strategy diversification is the best way to reduce risk. We have covered this in multiple articles, for example in this one where we discuss how an “imperfect” strategy can be a perfect fit for a portfolio of trading strategies because it’s a complementary trading strategy.
Tail risk management
No risk management is in place without some consideration of tail risk, an expression made famous by Nassim Taleb and which he developed into Taleb’s famous Barbell strategy. The strategy’s main idea is to benefit from tail risk – not to suffer from it like most traders do. Examples of tail risk hedging strategies could be, for example, diversification and put options.
How do traders manage risk?
Traders use different methods to manage risk. One of them is through position sizing and level-based stop loss orders. With the right position size and stop loss, one can limit the amount risked in each trade to a fraction of his account size. Most experts advise limiting the amount risked per trade to only 1-2% of the account balance. This increases the chances of bearing a losing streak if it occurs.
Traders also use time-based stop loss by closing their trades after a certain period during which they ascertain that the trades are less likely to work as expected. Some traders also use trailing stops to lock in profit as their trades progress in their favor. The big boys with large funds may use hedging strategies and diversification methods. It is not easy to practice both with a small account and discretionary trading — a large account and resources for algo trading are necessary to effectively apply those two strategies.
How do day traders manage risk?
Day traders are limited by time — they have to close their trades before the end of the trading day. So, they mostly make use of level-based and time-based stop loss strategies as well as position sizing. By trading small position sizes, day traders can reduce their risk of ruin and improve their odds.
Given the limited profit targets, day traders with good strategies may scale up their profit potential by trading larger position sizes with stop loss. To do that, the trader must have backtested the strategy’s reward/risk ratio to be sure it makes money in the market.
What risk management strategies do short sellers use?
The nature of stocks makes short selling difficult. To short-sell a stock, you have to borrow the stock first and then sell it, with the hope to buy back at a lower price to return it. One of the issues is that the lender may demand their stock and the broker will ask you to return it even if the price is not favorable. Another is the issue of short squeezes, and stocks can have unlimited upward potential.
Thus, when short-selling, the commonest risk management strategy is the use of a stop loss order. You can also diversify or hedge with a long position or buy call options.
Which is the most common risk management tactic?
Among retail traders, the most common risk management strategy is the use of a level-based stop loss strategy and position sizing. This lets them know beforehand the amount of money they are risking in a trade so they plan their trades according to their account size. In other words, from their account size, they would know how much to risk in a trade and plan their stop loss order and position size to reflect that.
For example, if a trader with a $10,000 account wants to risk only 1% of his account on a trade in EURUSD, for example, he would have to risk only $100 in that trade. He would use the right position size and stop loss size using this formula:
Account risk (dollar) = position size (Lot) x stop loss (pips) x pip value (dollar per pip)
So, if he wants to use a 100-pip stop loss, his position size would be
Account size/ (stop loss x pip value) = $100/ (100 pips x $10 per pip per lot) = 0.1 lot
- Where the pip value per lot for the EURUSD currency pair is $10 per pip movement in price.
So, if the trader wants to trade 0.2 lot, he would have to reduce his stop loss to 50 pips to maintain the same account risk, and if he wants to trade 0.5 lot, he would reduce the stop loss to 20 pips. Keep in mind that the lower the stop loss, the greater the chances of being stopped out by price gyration while the trading opportunity is still in play.
For institutional traders, the commonest risk management strategy is hedging and diversification. They have the capital and resources to implement such risk management strategies. Institutional traders often use the options market to hedge their positions in the equity market by buying protective puts, which over them the right to sell their stocks at a given strike price if the stock is to decline below that within the contract duration.
Why is risk management important in trading?
Risk management is very essential in trading, and there are many reasons for that. Trading is a very risky game. The chances of losing your capital are very high, and that can happen in many different ways. On one part, trading without a stop loss could expose a highly leveraged account to a catastrophic loss if a black swan effect occurs.
An example was in 2015 when the Swizz national bank unpegged the CHF from the Euro, leading the USD/CHF to lose over 30% in a matter of minutes. In such a situation, a trader using a 5x or even a 4x leverage is wiped out in that one trade if there wasn’t a stop loss order. Even a 3x leverage would get a margin call at least, if not wiped out by volatility-induced widened spread.
On the other hand, smart money’s tendency of hunting stop losses makes the use of stop losses quite painful sometimes. With a poorly placed stop loss, the trader is still at risk of losing his money, only that, in this case, the losses are gradual — slowly bleeding out.
So the ultimate risk management is to protect your account from both types of risks — catastrophic losses from black swan events and a slow bleed out from the very stop loss that was meant to protect against risks. Achieving that might require using a combination of strategies, such as level-based stop loss, position sizing, time-based stop loss, diversification, and even profit targets.
With the right profit target and level-based stop loss, you can have the optimal reward/risk ratio that allows you to use stop loss orders profitably. But you can only know that through backtesting and forward testing. But when you find that sweet spot for your strategy’s risk management, you can enjoy the benefit of protecting your capital while still maintaining optimal profitability, which is the hallmark of successful trading.
How do you manage risk in swing trading?
Managing risk in swing trading is much like managing risk in day trading in many aspects. However, a swing trade is exposed to overnight and weekend price gaps, which a day trade is not exposed to. So, apart from using a stop loss and other exit methods, swing trading requires optimal position sizing. With swing trading, you should trade with a smaller position size so as to reduce the amount you lose if the market gaps against your position.
Profit targets, time-based stops, and diversification are other methods that can be used in swing trading. With a profit target, the swing trader can have an optimized reward/risk ratio and also prevent the possibility of having a profitable trade turn into a loser if the market reverses. A time-based stop may be great for a not-too-volatile market, but it cannot protect against a black swan event. Diversification helps to limit risks generally because when trading non-correlated assets and strategies, the losses in one would be offset by the gains in another.
How do you manage risk with leverage?
Leverage is the factor by which you magnify your position size capacity using funds borrowed from the broker. To use leverage, the broker would require you to have a certain minimum balance known as the initial margin. The initial margin is inversely related to the leverage. A 1% initial margin requirement means that you can get up to 100x leverage. The higher the leverage you use, the less the adverse price move required to wipe out your account. If you are using a 100x leverage, for example, it means that a 1% adverse move in the asset you are trading is enough to wipe out your account.
The amount of leverage you use in any trade is dependent on your position size. Leverage can be deduced from the worth of the contract size divided by the account balance. For any given account balance, the higher the position size, the more the leverage. In a highly leveraged asset like forex and futures, the worth of a standard position is usually more than the trader’s account balance. For example, a trader with a $10,000 account balance trading a full lot size of EURUSD currency pair is using a 10x leverage because the full lot size is worth $100,000. If the trader trade 2 lots, he is using 20x leverage.
Thus, to manage risk with leverage is to reduce leverage by reducing position size or even remove it altogether by trading a position size whose worth is equivalent to the account balance. For a $10,000 account balance, that would mean trading just 0.1 lot size. In that case, you only get stopped out when the asset price goes to zero (or near zero due to spread and maintenance margin call rule). You can even go beyond and trade a lower position size, say 0.05 lot size on a $10,000 account. while the profit per trade may be low, you can never get stopped out.
How do you manage risk in futures trading?
In futures trading, you manage risk with a combination of the risk management strategies we have been discussing. But being a highly leveraged derivative, futures trading requires you to take care of your leverage. You do that with your position sizing as we explained above.
Risk management strategy backtest
Let’s go on to backtest a trading strategy without a stop loss. The example is naive, but it serves to prove that you should not use an arbitrary stop loss to any of your strategies.
These are the trading rules:
- We buy S&P 500 when the 3-day RSI is below 20,
- We sell S&P 500 when the 3-day RSI is above 70.
Let’s now include a stop loss of two times the ten-day ATR ( ATR(10) * 2 ). The total profits drops from 1.19 million to only 0.764 million and the performance gets more erratic:
Even with a wide stop loss we get stopped out a lot:
Even with a wider stop loss, it doesn’t beat our strategy with no stop loss.
The problem with a stop is that it takes us out of a trade when the odds of a pullback are growing, a typical feature of all mean reversion strategies, but also for trend-following strategies.
Here is an example from our strategy above:
We get stopped out on a weak day just before a rally! This happens often if you use a stop loss.
The best risk management strategy
The best risk management strategy is diversification and adding strategies that are complementary. You need to read this article for an example of the best risk management strategy. In that article, we give you a specific example of how two strategies increase returns and lower risk.
Yes, you read that right. It’s possible to BOTH increase returns and lower risk if you work hard with your strategies and know what you are doing!
Risk management strategy Frequently Asked Questions (FAQ)
We end the article with some typical FAQs we sometimes receive from the readers:
What is a good risk management strategy?
A good risk management strategy is backtested and “proven”. If you want to succeed as a trader, you need to accept that it requires a ton of work, and no one will help you (for free). You need to figure it out yourself. However, there are plenty of indications and help for free on this website if you are willing to spend hours reading and studying.
What is the 80% rule in trading?
When you trade, you soon figure out that just a few of your trades make most of the overall returns. The rest, 80%, is smaller losses and gains. Because of this, you want to make sure your risk management plan doesn’t stop you out of potential winners prematurely.
What is the 2% rule in trading?
It’s a very popular trading “rule” that says you shouldn’t risk more than 2% of your equity. If your equity is 100 000, you should never risk more than 2 000.
The rule might serve a purpose, but we have never seen it backed by numbers or empirical data-driven evidence. Again, don’t trust all you read: backtest yourself to find out if it works or not.
What is the best stop loss level?
We have never found stop-losses useful. And of course, there is no answer to what is best and worst in trading. The options are endless.
What is the best risk management for investors?
This website is mainly about trading, not investing. However, we can say one thing about risk management for investors: make sure you know what you are doing. Most investors are better off buying some passive ETFs or mutual funds, and not DIY.
What is the best risk management in FOREX trading?
First, we don’t recommend forex trading, please read here for why we don’t recommend forex trading.
Risk management is probably more important in forex trading than stock trading because of increased leverage in forex trading. Leverage bites – sooner or later. Thus, forex trader should focus even more on risk management techniques.
Do I need a risk management calculator?
No. We have explained in this article why you should focus on complementary strategies and backtesting. You don’t need to calculate anything. If you have many complementary trading strategies, you just need to execute and don’t calculate anything.
