The Nitty-Gritty of Risk Management
It seems like a sad fact of life that nobody wants to talk about risk management. I find it bemusing that people seem so okay with leaving a massive hole in their trading game.
Educators tell you to risk 1% of your account on any given trade, and walk away considering their job done. In truth, the 1% rule is a platitude at best, and a millstone at worst.
It’s a good rule for robots and system traders, because it’s hard to blow up an account using the 1% rule, but we discretionary traders were born to grasp bigger and better concepts.
If we think and trade creatively, we can do away with the out-dated 1% rule, which I suspect started with futures trading anyway. It has no real star power for us discretionary spot forex traders.
Your position size should reflect your objectives.
Risk management begins with your objectives. You want to make this much, but you can’t afford to lose more than this much. Really, that’s the essence of it.
The way you size your positions is of the utmost importance, and nobody knows this more than Dr Van Tharp, Market Wizard and trading coach, whom I was lucky enough to meet.
In emphasizing risk management and position-sizing, he told me he would target 25% while risking only 2% per month. Unthinkable for a 1% trader, who would quickly reach that threshold.
I started developing a position sizing model that let me risk 2% and make 25%. The 1% rule is grossly inadequate for a goal like this – setting the right objectives means we have to use the right methods.
Minimise your risk to your core capital
You can’t put toothpaste back in the tube, and you can’t undo the heartbreak that accompanies blowing up an account. Even if you lose half an account, you now need to double your money just to break even.
There’s a big difference between your own core capital, which you should protect tooth and nail, and the market’s money, which you’ve won fair and square, and which you can use to take a risk.
If I start by risking less than 1%, I can lock in a small amount of profit, and then begin trading more than 1% with no real risk to my core capital.
By trading smaller when my war chest is threatened, and bigger when I’m doing better, I can construct some very powerful and ‘risky’ trades without worrying for my future in the slightest.
When you realise that your core capital is your life’s work, and trading isn’t for everyone, you’re better able to control your actions, strengthen your psyche, and persist when times are tough.
The professionals know the nitty gritty of risk management is most definitely in their job description. If a big money manager ends the year down even 3%, they’ll face some pointed questions.
When it comes to scaling in to trades, you can also apply this theory of risk management by using floating P/L and a trailing stop to make up a dynamic but valid risk-management equation on the fly. Whoever said risk management wasn’t exciting?
Length of the trade
By its nature, a long-term trade is going to take longer to play out than a short-term trade. It makes sense to risk slightly more on these, since the floating P/L can still be accounted for in the interim and there’s less risk of getting stopped out or spiked by a news event.
- Short: probably less than .5%
- Medium: .5% to 1%
- Long 1% to 3%
If you give a pro trader a 50k account out of the blue and tell them to make as much money as they can, they won’t run with the 1% rule, or risk the exact same amount twice in a row. They trade what they see if front of them, so they only ever risk what’s wise.
Applying this way of thinking is exactly what’s needed to get out of the box and onto the next level. You’re not a robot that needs predictable structures. You’re a human, with human advantages.
Start trading the market that is in-front of you with positions as aggressive as your objectives and P/L will allow. If you’re up, go for more. If you’re down, claw it back slowly. This is risk management.
Risk Management is a process
It won’t come to you all at once, so meditate on it for a while: how much of your core capital are you happy to trade? Why, and how much profit are you hoping for?
Will you size your short and medium term trades differently from your longer trades? How much leeway for risk will you give yourself based on your own confidence level when taking a trade?