Pimp My Trade

Risk Management 101

Posted on June 2, 2009 by Adam

Do not just roll the dice with your trading

Although risk management is not the most sexy aspect of trading, it is certainly one of the most important. It is the first thing I think about before placing any trade, and it’s always at the back of my mind when I’m scanning charts.

But why pay attention to a topic that seems dryer than the desert? Because it could end up saving your account from going extinct.

Don’t Avoid Risk - Manage It

As traders, we take risks every day. Without taking on risk, we would not be able to function. Riskless investments yield very low returns, especially since the Fed has lowered short term rates to near zero.

In order to make higher returns, we have to take on risk. However, excessive risk will get you into serious trouble. The key to placing winning trades often comes down to how you manage your risk, and what potential reward that risk carries.

How much risk you are willing to take on should depend on your timeframe, trading style, and potential reward.

This amount should always be the same, and you should adjust your position size to ensure that. I recommend risking between 1 and 2 percent of your account equity on each trade, especially if you are new to the game. This means you can be wrong as many as 100 times and still have money left (that almost never happens). If you have a small account, and using 1% isn’t quite feasible, you may consider upping that amount to 5-10%.

If 1% of my account is $100, then I would risk no more than $100 on each trade.

Defining Risk and Reward

I define my risk as the difference between my entry point and my stop-loss - and yes, you should always use a stop-loss. Doing this limits your losses at a pre-defined amount. That amount should be how much you are willing to risk on the trade.

Set it too tight, and you may be whipped out of the trade, but set it too loose and you may end up losing too much.

In order to combat that problem, I usually enter trades near areas of support and resistance. For example, if I am looking to buy a stock, I would look to buy it as close to the nearest support level that I could. This allows me to place my stop-loss very close to my entry point, which minimizes risk.

From there, I adjust my position size to match my risk tolerance.

Let’s say there is $1 between my entry point and my stop-loss. I would plan on buying 100 shares. That is my position size.

In terms of reward, that should always be your secondary concern. Obviously, you should never take a trade that doesn’t offer any reward, but as long as you manage risk properly the rewards will tend to take care of themselves.

Reward is defined as the difference between your entry point and your target. You should always try and use a target price, even if it’s only a rough estimate. This will allow you to get an idea of your risk/reward.

Sizing Up Risk/Reward

Before taking a trade, I always look into the ratio between my reward and my risk. If my reward to risk ratio is greater than or equal to 2, I would consider taking the trade.

The better this ratio, the less often you have to be right on trades, so small changes can have a very big impact.

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