Risk Management

The term risk management may seem simple enough, I want to risk this much and no more, and as long as you keep your risk under that you’re fine. But it’s a lot more than that. You need to take into consideration the following factors:

• Starting capital
• The risk you are willing to take per trade as a part of your capital base, or initial stop loss size
• The biggest drawdown of your capital you are willing to take, i.e. the worst case of losing streaks
• The cost of trading in terms of commissions, spreads, slippage, interest and then running costs and tax
• The size of your trades or positions in the market
• The number of trades or positions in the market at once
• The cost of trading in terms of time, emotional management and evaluation

Starting Capital

The more starting capital the better simply because it enables you to take advantage of more markets and more positions, it reduces the costs involved as a percentage of your trading, and it reduces the costs imposed on the trader from a personal level.

The various markets do make it possible for a trader with as little as $2000 to get started.  However, to see real results by way of income or the return on capital being meaningful, the more capital you have the better.

For example, someone starting with $2000 is putting themselves at risk of high costs as a percentage of each trade, but they also will have to accept that even with a 100% return on this money over a year, it is still only $2000. Depending on the amount of work involved in trading, this may seem very small and hard to accept, creating risks of emotional costs.

When you do choose your starting capital, make sure you consider all the various markets available to you and to that size capital base.

Initial Stop Loss Size

As mentioned in the Trading rules module, the initial stop loss performs two functions; however the most important is preservation of capital.

Most experienced traders suggest that the absolute maximum a trader should risk on any trade is 3% of their available capital.  Any more than this is like gambling.  Going for a smaller figure is preferable, for example, 1 – 2 %.

The reason for this can best be described by the following table:

Two traders trading the same system with the same capital, risking different percentages of their capital (after costs), and going through a 6 trade losing streak (a very real possibility).

After 6 losses, Trader A still has over $9000 and has only suffered a 9.6% drawdown. Trader B on the other hand has lost over $4000 or 40.3% of their capital. In order for each trader to get back to their starting capital of $10,000, trader A needs to generate a 10.6% increase on their capital, trader B however needs to generate a 67.5% increase – that’s 6 ½ times more than trader A.

Drawdown

When determining your objectives you must ask yourself, how much 'drawdown' am I willing to tolerate? What you are really asking yourself is, if I want to make 50% on my capital, or $x amount per month, how low can I let my capital go before I find it emotionally too difficult to continue? Is it 20%, 40%, 60%?

Another way of putting it is; if i want to make $1000, what am I willing to risk to get it, is it $500, $300, $200 etc?

This is your worst case drawdown. Every system has drawdown periods where the system has a longer than normal losing streak, as shown in the table in the previous section on stop losses.

The higher the results you seek in trading whether it is growth or revenue, the higher the risk of considerable drawdown, and you need to know what you are willing to tolerate.

As a general rule, you want your worst case drawdown to be less than the return or profits you seek otherwise you're not really giving your capital any chance to grow; but ideally to get it to at least 2:1 ratio or better of return to drawdown.

You determine a system's drawdown when you back test the system (next section). The more back testing you do, the better idea you’ll have as to the drawdown you are most likely to encounter.

The Cost Of Trading

The cost of trading is an important factor because it does affect the results of a system. Back testing a system without considering costs may make a system look great, but as soon as you factor in commissions, spreads and slippage, it paints a different picture.

Traders who trade CFD’s and stocks on margin have to consider the costs of interest too. The longer the time frame you are trading the higher these interest costs are going to be.

When back testing your system, always be willing to factor in as much cost as possible so as not to give yourself false hopes; this includes brokerage fees or commissions, spreads, slippage, and any interest.

Please refer to Market Basics for various costs involved with different markets.

Position Or Trade Size

When you enter a trade you not only have to consider the size of your stop loss, but also the size of the trade itself, i.e. your market exposure. Two traders trading the same market with the same amount of starting capital, risking the same percentage of their capital but with completely different stop losses, will have completely different market exposure.

Here is an example:

Stock XYZ is trading at $45.

Trader A is risking 2% of $10,000 or $200 (before costs for demonstration purposes)
Trader B is risking 2% of $10,000 or $200

Trader A puts his stop at $44
Trader B puts his stop at $40

Trader A’s stop loss size is $1
Trader B’s stop loss size is $5

Trader A buys 200 shares, his risk of $200 divided by $1 (his stop loss size) is 200.
Trader B buys 40 shares, his risk of $200 divided by $5 (his stop loss size) is 40.

Trader A calculates his position size by dividing his risk of $200 by $1 (stop loss amount).  Number of shares to buy = 200.
Trader B calculates his position size by dividing his risk of $200 by $5 (stop loss amount).  Number of shares to buy = 40

Trader A’s position size as a percentage of his capital is 90%!
Trader B’s position size as a percentage of his capital is 18%!

Based on this, Trader B still has over 80% of his capital left to place more trades where as Trader A has only 10% left.

If your system was designed so that you only ever had to have one trade open at any given time, this is not a consideration, as you buy as much as your capital will allow you. However if you want to have the ability to take advantage of multiple trades at once you need to consider the size of your trades or market exposure as a percentage of your capital.

A simple method employed by stock traders in particular is to allocate no more than say 25% of starting capital per trade. This means the trader can have 4 trades open at once. When their capital increases they can then choose to allocate more to each trade, or open more positions.

Margin offers the ability to have more market exposure.

For example, if your stock broker offers a margin facility, normally 50%, they’ll only require you to have half the position size in your account.

Let’s say Trader A above used the margin facility offered by his broker, then his market exposure will still be $9000, however he needs to only put up $4500 of his capital to control that trade; leaving him with just over 50% of his capital compared to only 10%.

CFD’s (not available in some countries like the US), offer even more leverage on many top 100-500 stocks. They are a popular instrument in countries like Australia and the UK. A CFD will in most cases allow you to trade up to 20 times your initial investment (depending on the liquidity and other factors). The most common margin requirement is 10%.

So if Trader A above was using CFD’s and was offered 10:1 leverage on his position, although he would still have a $9000 position size in the market place, his capital requirement to control this trade (margin), would only be $900, thus leaving him over 90% of his capital to trade with.

Warning: Please refer to Market Basics for risks involved with leveraged instruments.

Other Costs And Risk Factors

A trader must never lose sight of why they are trading and to include any other costs such as time and management in their assessment of a viable business.

Time is one of the most overlooked aspects of trading. Time affords one the freedom to learn, practice, evaluate, research as well as trade and invest, however if the trader is spending 100 hours a week devoted to trying to make a living trading only to make a small amount of money, then what value is he or she putting on themselves.

Initially it is expected that a lot of your time is invested in the creation of your business, not to mention learning about the markets and learning about yourself. However at some point in time, the business needs to be making a profit where it’s more than paying for your time. I’m sure most who are trading a capital base of say $20,000 or more is not going to too impressed at the end of the day they work out their trading for less than $10 an hour.

Systems are good ways to overcome a lot of the time issues. Create logs using spreadsheets so you can easily log your trades and track your progress. This will save time in the long run. Also ensure you keep the necessary papers and statements in order and filed away for your accountant.

Emotional management is another form of cost and risk.

There is always a risk that overtrading, trading under duress, bad habits, a negative approach, poor discipline and so on, will cause errors, and errors cost money! We have programs in place to help with this because it is a serious consideration that no trader should ignore. These additional programs you may wish to purchase to further enhance your emotional management in the Resources Section

Risk Assessment Exercise

What's important at this stage is to think about your answers to the following. There are no right or wrong answers, in fact some of the answers you'll find a lot easier to come by once you start trading, at least paper trading. However it is essential that you at least put some thought into them now.

Starting Capital______________________________________________

Initial Stop Loss (risk per trade)_________________________________

Maximum Drawdown___________________________________________

Cost of Trading (per trade)_____________________________________

Position or Trade size (or margin)________________________________

Other costs__________________________________________________

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Move on to Step 5 - Module 2 > Back Testing & Evaluation