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.
67/27 = 2.48
Hence our R-multiple is 2.48:1.
Our potential profit is therefore 2.48 times our potential loss.
While analysis on some trades may tell us to take a wider stop loss than others, and wider profit targets than others, we can maintain risk management control by reducing the size of such trades.
In this way, we should be able to keep tight control over the percentage of the account that is at risk on any one trade.
If you're committed to keeping the loss on any one trade to just 1% of your trading account, then it means you may need to decrease the leverage on trades where technical analysis tells you the stop loss should be at a wider absolute level than others.
This is important because having too narrow a stop loss could mean that our trades will be prematurely closed out.
It’s not a good idea to make your stop losses so narrow that you're essentially attempting to take “no risk” trades. Even if you're getting your entry points mostly right you still need to allow some leeway for brief retraces. Otherwise, you could be missing out on too many highly profitable trades.
As an example, suppose we're tracking the Dow Jones 30 index. There have already been some falls in the index on bearish sentiment, but we notice the index appears to have entered a consolidation phase over the past few hours and is trading within a narrower range.
We view the peak point in this relatively narrow range at 24,130, a price level the index hits twice before retracing, marking an area of resistance. The lowest point in this trading range is 24,108.
In the belief that the index will likely breakout to the downside, we set a sell order at 24,108, with a stop loss just a short distance away at 24,115. We were right in thinking the index would breakout to the downside; it does so within the following 40 minutes and the sell order is transacted at 24,108.
We set a profit target for the trade of 44 points, twice the height of the prior trading range. After reaching 24,103, the index bounces up to 24,116 and the trade is closed out due to the stop loss, leaving us with a small loss on the trade.
However, within seconds the index is back down again and heading well past 24,103. In fact, it has reached the original profit target of 44 points just ten minutes later, and is trading at 24,085.
In short, we missed out on a profitable trade because we set the stop loss at a much too narrow distance from the point of our buy order.
Had we instead used the last upper price levels from the consolidation phase, say at 24,130, we would have had a profitable trade.
Clearly, setting the stop loss at an overly narrow distance away from your market order can be counterproductive. Rather than using fixed distances arbitrarily, you need to be able to take into account technical indicators such as moving averages along with basic factors such as support and resistance levels.
At the same time, you should be comfortable with the level of potential monetary loss implied by the position of the stop loss. If you use the 1% rule, for instance, you must ensure that the stop losses themselves are not set an overly narrow level from your market orders.
At times of higher market volatility you should also be prepared to consider implementing wider stop losses compared to days when market volatility is lower. When volatility is higher you'll notice that your usual stop losses have a tendency to get closed out more often.
Reviewing your trades
Properly managing risk and your overall trading strategy means you should document your trades every day. This means having a record of the level at which orders and stop losses were made and the outcome of each trade.
Understanding why a trade wasn’t successful or how profit could have been further maximised could help you to become a better trader in the long run.
At the same time, we need to compare our trading actions and results to our own pre-planned trading rules and strategy. In this way, we can aim to assess our actual compliance with the trading strategy as well as our overall effectiveness.
Reviewing your trades should help ensure you're obeying your own rules but also allow you to pinpoint your weaknesses, ultimately enabling you to improve long-term trading performance.
What you trade
There is also the small matter of the assets we choose to trade. These days, online trading platforms enable you to trade a wide variety of stock indices, individual shares, commodities, forex and cryptocurrencies.
You may be drawn to a particular asset class because you feel you better understand what drives it than others. However, you should always bear in mind that spreads can differ quite significantly between one asset or another.
For instance, a stock market index such as the highly popular Dow Jones 30 may have a much tighter spread than a cryptocurrency. Spreads can impact your trading strategy, with wider spreads potentially raising your costs of trading.
You therefore need to consider whether the spreads on offer in a given asset are a good match with your trading strategy.
You also need to consider the correlation between assets, especially when you have more than one trade open at any given time. Having two positions open in different assets that are positively correlated, as opposed to two positions in assets that are negatively correlated, increases your overall risk.
As an example, suppose you open long positions on both the FTSE 100 and the Dow Jones 30. They are positively correlated as they are major global stock market indices and will more often than not move in the same direction as one another.
Conversely, suppose you simultaneously had a long position in gold and a long position in the S&P 500. In this case, you might often observe a negative correlation as gold may fall when risk appetite is strong but rise when investors pull their funds from stock markets and put their money in safe havens. As one of the world's other major stock market indices, the S&P 500 tends to rise when risk appetite is strong.
Mapping your risk and profit
By planning our trades and having a proper risk management strategy, we should know our potential profit and maximum loss before we embark on any given trade. This is in stark contrast to an amateur approach that can be highly charged by emotion or gut feeling.
If a price moves rapidly against us when we don't have a stop loss in place, we may easily be tempted to holding on to the position in the hope that the situation will reverse itself. Of course, we could then easily find that we rack up even greater losses.
Similarly, without the discipline or a pre-planned profit target we might be overly tempted to hold on to a winning trade for too long, only to watch the profits evaporate before our eyes.
In contrast, setting reasonable profit targets and maintaining strict control over our losses should help us boost our trading profitability over the long term, while firmly eliminating unnecessary nasty surprises and emotion from the equation.
Documenting our trades and then constantly reviewing our execution and performance should also help us to become better traders.