Understanding Risk Management

Risk management should be a major focus of your trading strategy.

The numbers do not lie; Fail to respect risk % and position sizing and you will have a short lived trading career.

Even experienced and successful traders should be constantly refreshing the basics about market risk and in this article, I am going to cover:

• Why you should focus on risk management
• How you can lessen the impact of losing streaks and draw downs
• 3 steps to ensure proper risk management

Risk Of Loss Is Real

What we have here is, on the first column, the trading system win percentage.  The win percentage in this system is essentially the percentage of trades that are winning trades versus the percentage of trades that are losing trades (win loss ratio).

A good system will typically fall somewhere in the 60% to 80% range. If you’re winning 60% of the time and losing 40% of the time, and assuming that the size of your winning trades is similar to the size of your losing trades, you will end up making money.

This is not dissimilar from what the casinos do.

The casinos have maybe a 3% or 4% statistical probability edge in their gambling and they’ve built Las Vegas on that 3% to 4%. So having a 10% edge, a 60% win rate, is actually quite good. Many systems that I am familiar with, that I’ve traded, fall in that 65% to 70% range.

Now let’s just look at one of these rows, the 65% win rate.

The columns give us the different probabilities for losing streaks. Now notice, with a 65% win rate, you have a 100% probability, meaning there is a certainty that you will have three losing trades in a row, it’s unavoidable, and you have a 50% chance that you will have four losing trades in a row.

Furthermore, you have about a 10% probability that you will experience a six to seven trade losing streak and a 1% probability that you will experience an eight to nine trade losing streak.

The maximum – there is really no maximum, but this is like the 99.9% probability, you could get as many as 13 losing trades in a row. Can your risk tolerance handle that?

Winning Streaks & Losing Streaks Come In A Random Distribution

Winning trades and losing trades tend to come in clusters.  Day traders could rack up many losses in a day.

So, you might have a series of ten trades of which eight or nine are winning trades, and you only have one or two losers.

But then that will be followed by a series of ten trades where maybe six or seven of those trades are losing trades and only four or three are winning trades.

We have trending systems that will make money when we are in a trend, and if it’s a strong enough trend, we will have many winning trades in a row. However, when price reverses or starts to move in a channel, a trending system will have a higher proportion of losing trades.

Similarly, a channeling or reversal system or fading system, as it’s also called, will do very well when price is going sideways and moving in a channel. However, when price breaks out and starts trending, a channeling system can run into serious trouble.

And because markets move in waves from trending to consolidating or sideways and then again from sideways moves to trending moves, because of the nature of the markets, it’s natural that winners and losers should come in clusters.

Now consider the 1% probability factor in the table, having eight or nine losing trades in a row.

If you consider that you’re trading 250 days a year, that means that once or twice during the year, you will likely see one of these eight to nine trade losing streaks and you have to be prepared for it.

Your system is still 65% profitable, but you have to prepare for the shock of having a long losing streak and you have to be able to trade through it, you have to be able to survive it.

Can You Recover From A String Of Losing Trades?

Now that we understand the probabilities of a losing streak, we must now understand how much money we need to make back to recover from our losses (our draw down).

Imagine that your trading account is down 5%, that’s not something inconceivable, that happens quite often.

In order to get back to your starting point, in order to recover what you have lost, you need to make 5.3%.

Here are some examples:

• You started out with $10,000 and your account dropped down to $9,500, you’ll need to make 5.3% over that $9,500 to get back to $10,000.
• If your account draws down 10%, you need to make 11% on the remaining account to get back to where you were.

Consider now if your account is drawn down by 25%, now you need to make 33%, the remaining account has to grow by a third in order to get back to where you were.

Or worse yet, if your account is drawn down to 50%, you need to double the size of your remaining account in order to get back to where you were.

Let’s consider the 1% probability where you can have 8-9 losing trades in a row.

Now yes, 1% is a very low probability. But again, you’re trading 250 days a year, so I would suggest that that 1% probability factor is going to hit you once, maybe twice, during the year. For those one or two occasions where you have a losing streak of eight to nine trades, your account has to be able to survive.

Let’s consider a scenario where on every trade, you are risking 5% of your account. When you get this eight to nine trade losing streak, if on every trade you are risking 5% of your account, your account — and I’m simplifying by not compounding, but your account will go down as much as 40%!

And if your account has gone down 40%, you need to make 67% on the remaining balance to get back to where you were.

On the other hand, consider the scenario where you’re risking 1% on every trade. Now when you get an eight to nine trade losing streak — and let’s round it up, let’s say a 10-trade losing streak. Now, you’re losing 10%.

You only need to recover 11% and that is very doable on a solid system, especially when you consider that losers and winners come in clusters. So if you’ve just gone through a series of 1% probability losing streak, odds are that this will be followed by a strong series of winners, and drawing down 10% on your account is eminently survivable.

What Is An Effective Risk Management Plan?

To understand this and keep ourselves in position to recover from the losing streaks we are sure to have, we need to factor in three items.

1. Risk Per Single Trade

This was hinted at when we talked about losing streaks and how much you were risking during the losing streaks.  You know that the more you risk per trade, the more chances you will have a draw down that is hard to recover from especially if you hit the 1% losing streak probability.

2. Daily Or Weekly Circuit Breaker

As a trader, you have to decide how much money you are willing to lose in total to stop trading during a specific time frame such as weekly or daily trading activity.

You will find that there are days and weeks when the markets are simply not cooperating. You might be in an environment that is completely news-driven, where no trend can take a hold, where the market chops around erratically. On those days, if you’re following your system and your trade plan, you will possibly get some pretty heavy losses.

You may go back to that probabilities table and decide that 10% of your account is as much as you’re willing to lose in any one day. Or you may be more conservative and only be willing to lose 5% on your account on any one day and that could happen if you get five losing trades in a row.

3. Maximum Drawdown You Are Willing To Take

You might not get large losers every day, but you may find that over a period of weeks, your account is gradually decreasing, slowly but surely decreasing. At which point do you then decide that your plan or your system is no longer working?

You need to have in mind a maximum draw down level for your total account that will signal to you that

1. You have to redo your homework,
2. You must redo your analysis,
3. It’s time to take a fresh look at your trading system & consider changes to it,
4. Consider changes to the instruments you are trading,
5. Consider changes to the time frames you are trading.

This will in all likelihood be a relatively large number, perhaps a third of your account. If your account has drawn down by a third from its peak value, then that is a pretty strong indication that something is not working.

• It could be something in the environment
• Something fundamental, maybe a fundamental change in the markets that you are trading
• Your trading system is not very adaptable and has not been able to function properly in the current environment.

If that happens, reassess your trading plan and your system.

So for proper risk management ask yourself, how much are you willing to risk on each and every trade, how large of a loss am I willing to take on any single day or week, and how much of a loss will I accept before reassessing my trading system and plan.

Positing Sizing Example

Consider a $10,000 account and let’s look at several different risk scenarios. We’ll start with the scenario that says you’re willing to risk 2% per trade, so that would be $200 on each trade, or 3%, 4%, or 5%, and 5% has, of course, the largest risk, $500.

If you have a trading system, you should have done a back test on it, you should be able to demo trade your trading system, and your goal partly has to be to determine what the average risk for your system is. You determine this by looking at either your back test or looking at the record of demo trades that you’ve taken and calculate the average losing trade, that’s your average risk.

Let’s assume in our example that the average losing trade for your Forex trading system is $200 per trade. What does that mean?

• If you’re using a 2% risk maximum, $200, and your average losing trade is a $200-loss, then obviously that means that you can trade one contract or one share of whatever the instrument is. So if you trade one share and you have a losing trade, you’ve lost $200.
• At the 3% risk level, that’s $300. In theory, you should be able to trade one and a half contracts or shares, however, you cannot buy one and a half contracts or shares, so you’ll round this down, so if you’re willing to risk 3% and your average loss is $200, then you’ll only trade one contract or share, so your risk is going to be less than 3%.
• For a 4% account, you have an average risk of $200 per trade, you can risk up to $400, which means you can trade two contracts or two shares.
• For the 5% risk where you can risk up to $500, you’ll also round it down. Since you cannot buy a fractional share of stock, you’ll simply buy two shares and risk $200 each for a total of $400.

We can actually express this as a formula to calculate how many shares or contracts you can trade:

So here we’re taking our example of the $10,000 account, assuming a 2% maximum risk per trade, and then we look at the average losing trade — and in this example, we’re looking at the futures for the Dow Industrials, and we’re saying that our average risk is 20 points on the Dow. Each point is worth $5, so that’s $100 average risk per trade.

By just doing this calculation, we determine that we can trade two contracts of the Dow Futures. The formula is simply to take your account size, multiply it by the risk percentage you’re willing to assume, and then divide it by the average loss, and if you have the average loss calculated in number of points or number of ticks then you just multiply that by the price per tick.

We talked earlier about 2% through 5% risk, so let’s for a moment refer back to the losing streak table.

If you assume a maximum risk of 2% per trade and your system has a 65% win rate, then you have a 1% probability of having 8 to 9 losing trades in a row that means that your account could drop by 16% to 18%.

Now refer back to the recovery table.

Our draw down would fall somewhere between the 15% and 20% entries in the table, so we would have to recover between 17.6% and 25% to get our account back to where it was before the losing streak. Not great, but recoverable.  Any more than that it becomes very difficult to recover.

A rule of thumb  is to risk a maximum 2%, but if you can, risk only 1%. With a 1% risk, you can survive many storms.

The flip side of the 1% risk as mentioned earlier is that you will not be able to make as much money on each trade. If you’re only taking 1% risk then the sizing formula will tell you that you can only trade 1 contract, not 2. That’s the balancing act, you always have that balance between how much risk you are willing to assume versus how aggressively you want to pursue gains.

Failure to respect risk will kill you. I know it’s very tempting to place 5% of your account on a trade that looks fantastic, but believe me, you only need to have a few losses, each of which is 5% before your account is depleted enough that it becomes harder and, in time, impossible to trade.

Key Takeaways

By now there should be no question about the importance of risk management.  The numbers do not lie and many traders have burned through their trading capital by taking a flippant attitude towards risk in their trading.

1. Before you trade, decide how much you’re going to risk per trade. Are you going to risk 1% or 2%, 5%, 10% (at 10% you may as well give you money to charity right now, because I guarantee you your account will be depleted very quickly). The rule of thumb is no more than 2% and if at all possible, try to keep your risk per trade down to 1%.
2. Determine your circuit breaker level. How much of a loss are you willing to take in any given day or any given week before you decide to stop trading for the remainder of the day or the remainder of the week.
3. Determine the draw down size that will cause you to reassess your trading plan and your trading system. How far are you willing to let your account drop from peak before deciding that whatever you’re doing is not working and you need to do something different?
4. Once you’ve made these risk management decisions, write it all down. I know, it’s going to be just three numbers that you’re easily capable of keeping in your head, but write it down in your log, in your trader log, write it in your journal, and write it on one of those nice yellow sticky notes and paste it on your monitor so that you will not forget.