Last Updated on Dec 18, 2019 by James W
Risk management is the lifeblood of trading strategies. What has been proven over time is that your reward is predicated on the risk that you take. The more your risk, the greater your reward. Prior to employing a trading strategy, you want to define your risk management and generate a trading plan that will incorporate prudent risk management.
What is Risk Management?
Risk management is a structure that you design which defines the amount of capital that you are willing to risk generating the returns you are looking to experience. A great example of risk relative to reward is a lottery ticket. In most cases, you are risking a small amount for the opportunity of great rewards. In most instances the chance at success is very limited and that is why the upside is so great. When you invest, you want the odds in your favor, so you need to create a risk versus reward plan where the odds are much better than winning the lottery. It’s not uncommon for traders to expect to generate gains that are 2 to 3 times higher than the amount they are willing to risk.
Creating a Risk Management Plan
Prior to risking your capital, you should develop a risk management plan that will generate a winning strategy. If you are trading a trend following strategy, your goal is to catch the trend. Since trends only occur about 35% of the time, you want to make sure you take advantage of the trend. You should be willing to risk about 33% of the profits you expect when you design a trend following strategy. For example, you might risk $100 dollars on each trade expecting to generate a return of $300 when you win. This would allow you to win only 33% of the time and still make money. On your first 9 trades, if you win 3-times generating $900 in gains, and lose 6-times creating $600 in losses, it would provide $300 in gross profits.
How to Employ Risk Management on Trades
To incorporate risk management into your trading strategy, you want to employ stop loss and take profit orders. A stop loss occurs at a specific price when your loss equals your target. Your take profit is executed when the price of the asset you are trading hits your target level. You can enter stop loss or take profit orders with your broker in advance or place them when they get to a specific level.
You can calculate the order levels or look for specific prices such as highs or lows that might allow you to avoid the market running your stop just to turn around and move in the other direction. You can also employ trailing stop levels. Here you would move your stop loss order up or down as the market moves in your direction. In a trend following strategy, this technique works well as it allows you to follow the trend while mitigating your potential loss.