Trading Risk Management

Trading Risk Management

As with any trading strategy, risk management and discipline are key ingredients for success.

Basic risk management includes 1) proper position sizing, 2) use of stop loss orders, and 3) risk-reward-ratio.

Proper position sizing. 

Typically, a trader should not risk more than 2% of his entire portfolio. That does not mean his positions should be 2% of his portfolio.  There’s an important difference.

If a trader determines that a new trade has a 20% max downside, his portfolio is $100K (equity not using leverage or margin), and wants to use 2% max loss rule then his position size should be $10K.

Because if he loses 20% of $10K, that’s $2K, which represents 2% of his entire portfolio’s equity ($100K). Expressed in a formula: Position = (Max Loss (i.e. 2%) * Portfolio Equity (i.e. $100K)) / Max Downside (i.e. 20%).

Stop Loss orders. 

Traders should place a Stop Loss at such price level so as to allow for normal movement within a trend, giving it room to breathe and bounce back, yet not too far. One common technique is to set a Stop Loss to below the low of the most recent trough for an uptrend. In the case of COMP (Compound) in the below chart, the most recent trough was around $550.

Target an RRR. 

Using the aforementioned Stop Loss strategy, if a trader were to Buy COMP on a pullback around $600, the downside would be $550 ($50 or 9%) and his upside would be $700+ ($100+ or 17%+) for a decent risk-reward-ratio (RRR) of 1:2 or better (50 / 100+).  Many traders target a 1:3 ratio.

Here’s also a helpful RRR for risk management using RRR.