Risk management: the no-fun and must-see part of trading


Your risk management strategy could decide whether you will survive the next market reversal. If you don’t have a trading plan in place, here are some ideas to get you started.

5 minutes to read

Photo by Dan Saelinger

Key points to remember

  • Know the risk management variables you can control
  • Traders must decide how much of their total capital they are willing to risk and how much they are willing to risk on each trade.
  • It may be smarter to minimize the effects of lost trades instead of maximizing winners

You can read thick books on risk management, write algorithms as long as your arm, and test strategies until you turn blue. But none of this guarantees that you will make any money or guarantees against loss. After all, look at how much major financial institutions lost during the Great Recession.

Managing the risk of your positions doesn’t have to be tedious. Most are common sense, the goal being to ensure that a transaction, or series of transactions over the course of a month, quarter, or year, does not have the potential to create such a large loss that you cannot continue to trade. Think of it as the financial equivalent of being hit by a tricycle, not a bus, if you are crossing the street.

The risk is relative – in a way

So what constitutes being hit by a bus? These are different things for different traders. For example, with $ 10,000 in your trading account, how would you feel if you lost $ 8,000 in one month? Would that prevent you from continuing to trade? It could, especially if that $ 8,000 can only be replaced by making winning trades with the remaining $ 2,000. But if that $ 8,000 is a small percentage of your resources, the loss might not be a big deal.

Let’s look at the coin toss. You can guess a coin toss, and if you’re right, you win $ 1. If you get it wrong, you win nothing. You are more interested in how much you are likely to walk away with after flipping the coin several times. In that case, you can take $ 0.50 (the expected value of this coin toss game) and walk away. Most of you would probably choose to flip the coin. Why? Whether you made $ 1, $ 0.50, or nothing would hardly make a material difference to most people. But if the amount you win or lose is more, then you will have to decide which loss is too much to bear. This may be difficult for some people, but it will make the rest of your risk management decisions easier.

Defined risk (simplified)

Generally, traders need to decide how much they are willing to risk. For example, suppose you decide not to risk more than 20% of your trading capital. This leaves you with 80% of your base to continue trading in an attempt to make up for losses. But how much should you risk on each trade? This is another point to consider. Suppose you decide not to risk more than 5% of your trading capital on a single trade. This means that you can make about four trades, each risking 5% of your principal, and have a maximum overall risk of 20%.

Of course, setting a maximum loss for your account assumes that you can identify the maximum loss for your transaction. For defined risk trades such as verticals, iron condors, butterflies, timing deviations, etc., you can view the maximum potential loss. Launch the thinkorswim® platform, select it Analyze tab, load the different strategies and examine the maximum potential loss before placing the trade. One approach to consider would be to take 5% of your trading capital and divide it by the maximum loss of the position. This would give you a target number of spreads.

Trading odds? Use them

If you are trading unhedged positions like stocks, mutual funds, or short put options, it is a bit more difficult to determine how much you can risk with a single trade. You might think that using stops defines your risk. But once the stop is activated, it becomes a market order seeking to be executed at the next available price. If the stock or index goes up or down significantly after the stop is activated, you may not exit your position at a price close to your stop. A more conservative approach would be to look at a likely movement of the stock or index over a period of time such as a day or a week.

One way to do this is to use the probability cone on thinkorswim. This helps you see what range of 68.27% (one standard deviation), 95.45% (two standard deviations) or 99.73% (three standard deviations) is likely for a stock or index (see Figure 1). . You might not think that a standard deviation move is likely while you are holding your position, but these “black swan” moves can come out of nowhere. (COVID-19 crash, anyone?)

thinkorswim platform probability analysis table

FIGURE 1: PROBABILITY CNE. On thinkorswim, select the Analyze tab then the Probability analysis sub-tab to display the probable price ranges. Chart source: The thinkorswim platform. For information only.

Your time frame when looking at the potential loss on a trade with indefinite risk should match the time you plan to hold the position. If you think you could hold positions for a week or a month, you need to consider greater risk. With more time, there is a risk of a larger price movement.

If you factor in the potential loss of the underlying stock or index making a big move against you, keeping the total risk of all of your positions below a maximum risk cap can help avoid catastrophic losses.

How much can you lose

When you risk a smaller percentage of your trading capital, you tend not to have big winners or losers compared to your total trading account. A trade can have a maximum profit or loss, but when combined with other transactions that might generate or lose a lower amount, the effect on your account is reduced. It’s bad if you only trade winning trades, but who does this? Sometimes it can be smarter to minimize the effects of losing trades rather than maximizing winners. Additionally, you may want to consider keeping the risk of all positions fundamentally equal. One transaction should not represent considerably more risk than others.

If you use a set of criteria to identify which trades you want to make, whether based on probability, volatility, technical analysis, or fundamental analysis, every trade has roughly the same potential to win or lose. money than others. . If you start to have a “favorite” and decide to risk twice as much money on this trade as the others, that favorite can end up breaking your heart (and your trading account) if it turns out to be one. losing. In general, you don’t want a job to carry disproportionate risk.

The 20% rule is useful if you tend to take positions and not pay much attention to it afterwards. But if you are watching your positions throughout the trading day and have the discipline to exit or hedge positions against you, it may make sense to increase the percentage of trading capital at risk. How much you want to increase depends on how much discipline you have to exit a trade if it goes wrong. Instead of looking at the maximum loss of a position, you can consider the maximum loss you are willing to take when calculating the number of contracts you are trading. For example, you might consider selling straddles or strangles before an earnings or news announcement when implied volatilities have been pushed up. A short straddle has a potentially unlimited loss on the short call side and significant loss potential on the short put side. But it does happen if the stock goes very high or reaches zero, respectively, and these two events are often unlikely, but it’s always a possibility. So you can look at volatility, determine a likely price range, and see what your losses might be at certain prices (the Analyze tab is useful here).

If you have enough experience in trading these scenarios and are sure to exit trades when you need to, you can make a larger trade than indicated by the maximum loss method. Because you are watching what the action is doing tick by tick, if that position hits a loss that you have determined is too much, under normal market conditions you can try to exit the entire position or parts of it. .

Risk management is new. The inability to manage risk is probably the most important aspect of trading that retail traders and investors often overlook. It doesn’t have to be fun, and it’s definitely not the first thing that comes to your mind when you think of trading. But when you realize why you are trading – to make money – then you need to make sure you don’t get knocked out of the game before you’ve even learned how to play. Using risk management techniques, such as those detailed here, could work for different market conditions. It is safer than having no risk strategy.

Kevin Lund is not a representative of TD Ameritrade, Inc. The materials, views and opinions expressed in this article are solely those of the author and may not reflect those owned by TD Ameritrade, Inc.


About Author

Comments are closed.