Risk Management Strategy (Backtest)

Last Updated on November 12, 2022

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.

Table of contents:

What is a risk management strategy in trading?

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.

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.