It’s all too easy to disregard the importance of risk management when it comes to trading. But remember, even if you've been enjoying an excellent rate of success in percentage terms, you could all too easily lose a high proportion of your gains should just a couple of trades go wrong.
That's the danger, unless you use a robust risk management system to ensure you're keeping the losing trades under control.
Becoming a consistently profitable trader over the long term in large part boils down to being able to professionally manage both your profit points and your stop-loss orders. Rather than stumbling into a trade with no strategy on a wing and a prayer, this is all about serious planning.
- Firstly, we need to understand why we are taking the position and related to that is the likely profit target we should set, from entry point to exit point.
- Secondly, we should guard against the unexpected, just in case things don’t go as we anticipate.
If we can minimise our losses from the trades that go wrong and maximise the profits from those that go right, we should be well on the way to becoming a consistently profitable trader. We'll be all-the-more successful if we can also ensure that a higher proportion of our trades are profitable than not.
This part of the equation goes back to being sure why we're making the trade in the first place.
Many traders swear by the so-called 1% risk rule. In short, this means that when a trade doesn’t go our way we never lose more than 1% of the value of our trading account. Setting such a relatively low limit on maximum losses from any single trade could put you well on the way to long-term profitability.
What this means is that if you have a trading account with £10,000 in it, you'll set your stop losses to ensure that the maximum you lose on any given trade is £100. While it may appear conservative, this could easily add up to a good long-term return, even if we set our minimum profit target for each trade at just 1.5% of the account.
So, even if just three out of five trades in any given day were profitable, we would still be making an average of £250 profit on each trading day.
On certain trades we may choose to seek a higher level of profit if technical and fundamental analysis tells us our profit target on a given trade should be higher. This should increase our long-term profits, especially if we maintain the 1% stop-loss discipline to minimise our losses.
The 1% rule won’t necessarily be optimal for everyone. For instance, if you have a very large trading account, say with £80,000 in it, you may want to set your maximum loss at a lower percentage level.
Conversely, professional traders, with a long track record of delivering consistent profits, may choose to set the maximum stop loss at a higher percentage of their trading account, perhaps as high as 2%, or somewhere in the middle, at 1.5%.
If this were the case, however, they would also need to target a higher percentage level of profit from each trade.
For many traders though, the 1% rule engenders a comforting level of self-imposed discipline. Personally, even with a trading accounting of £50,000, I’d rather lose a maximum of £500 on a single trade than £1,000.
If we impose proper risk controls and aim for reasonable profit levels on each trade, then it follows that the level of funds in our trading account will closely determine how much profit we make on an average trading day.
Underfunding your account but going for fairly high levels of daily profit is a risky strategy that could see your trading account balance rapidly depleted. It’s important then to have in mind an average daily profit target so as to ensure that there is sufficient capital in place.
For instance, if we're aiming for an average daily profit of £500 then we are likely to need a trading account with £20,000 in it rather than £10,000. For those of us who are fairly new to trading, it’s well worth practising with a demo account to get a good idea of the profits we should expect from our strategy.
Some of us may also wish to go back to using a demo account when we want to experiment with new strategies.
And remember, the nature of trading means that some days will be a lot more profitable than others. There is an emphasis on the word average because we shouldn’t feel under pressure to get to that level on every single trading day. On some days, we may well make £1,000, double the daily average target, while on other days we may even incur a net loss.
Risk:reward ratio is an important concept in trading, being a fundamental element of any trading strategy.
Let’s go back to the earlier example of a £10,000 trading account where we were ensuring that a maximum of 1% of the account value was at risk on any one trade, while also setting a minimum profit target of 1.5% of the account on each trade.
Some investors claim that the minimum risk:reward ratio for any trade should be higher than in this example, with many typically citing 1:2.
However, in a day trading strategy where you're making at least five trades each day, this may not be necessary. At the same time, this does depend on what percentage of the trades are successful. The higher our win rate, then the lower the ratio needs to be.
Meanwhile, with a risk:reward ratio of 1:3 we only need a win rate of 25% to breakeven. Going back to our risk:reward ratio of 1:1.5, then we would need a win rate of 40% to breakeven.
In our earlier example of a £10,000 trading account using a 1:1.5 risk:reward, giving us an average profit of £250 per day, our win rate was 60% (three out of five trades were profitable).
Using our historical track record of trades, we should be able to get an estimate for our long-term win rate. We then need to ensure that our risk:reward ratio stacks up to give us our desired average trading profit.
If you don’t consider yourself to have a sufficiently long track record of active trading to achieve a reliable win rate, then you could also apply the trading results from a demo account. Once you're happy with your risk:reward target, you've got the ability to screen trades according to whether they meet your minimum requirements.
While it might be tempting to take on trades that fall below your minimum threshold, over time this approach could significantly erode profitability. So, if you calculate the risk:reward from a trade at 1:1.2, and your minimum is 1:1.5, then the trade doesn’t qualify for your strategy. If a trade falls short of your risk:reward, then it’s best to pass it by.
Billionaire George Soros once said: “It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”
It is ok if a trade profile is above your minimum risk:reward threshold. Having more trades with higher than average payoffs should boost our average profits over time.
A popular way of assessing the potential profit of a trade is by using the so-called R-multiple. R itself, also referred to simply as risk, measures the distance from where your order is transacted to the point where you have implemented your stop loss.
For example, suppose we implement a buy order on the FTSE 100 at 6,923 and a stop-loss order at 6,896, with a profit target at 6,990. R, the distance between the buy order and the stop loss, is: 6,923 – 6,896 = 27.
Next, in order to calculate the R-multiple we need to know the distance between the buy order and the target price. This is 6,990 – 6,923 = 67
We can now calculate the ratio of the potential profit to the potential loss of the trade.