For this article I would like to illustrate three particular scenarios which deal with various aspects of risk management. In addition to the required and necessary skill-sets involved in consistent speculative trading, maintaining a constant and disciplined approach to capital preservation is ultimately the number one objective for any professional in the field. Failure to adhere to these risk management principles will typically result in ongoing frustration and concern for any individual aspiring to attain market success.
In the classroom learning environment, I always advise my students to maintain a risk parameter of between 1% and 2% of their account balance. Therefore, should they be working with let's say a $10,000 trading account, any open trades and positions should never carry a greater potential financial loss of between $100 to $200. By sticking to this strict rule, the risk-aware trader can safely engage in the markets with control and comfort in knowing that they can endure a series of losses in the market without wiping out their account, and still have plenty of capital on hand for further upcoming trading opportunities. Remember that trading is not in essence a game of being right, but rather a strategic chess match of longevity.
As simple as this logic may sound, when a trader's emotions creep into the equation, the lines often become blurred and it actually can result in an increasing challenge for the individual market speculator to remain level-headed and focused. Consistent risk will result in consistent money management and as we will see in the below examples, will greatly affect the final P/L of all traders:
Scenario 1 – The Nervous Trader
Trader A is of a nervous nature and accepts that there is risk in trading and decides to stick to a 1% risk level on the account as this is what makes them comfortable. They take their trade, planned well in advance and place the order knowing that they have done everything they can. The result is a stop-out for a 1% loss. Moving on a few days later, they then see another opportunity in the market. Again, they risk just 1% of the account and again, the market proves them wrong. Feeling a little beaten up, even though the plan was followed through flawlessly, they decide to take a few days off and come back refreshed at a later date. Upon their return, another trade presents itself and is consistent with the trading plan.
However, as the trader is setting up the order, they remember the last two trades and start to feel uncomfortable thinking about a possible third loss in a row. So, to make themselves feel better, they decide to risk just 0.5% of the account and set the orders in place. After returning to the screen some hours later, they see that this trade worked out exactly as planned and has closed itself out after hitting the exit target. The risk-to-reward on the trade was at 1:3, resulting in a gain of 1.5%, overall. However, the nervous trader suffers because after three trades, they are still down by 0.5% as they had lost a total of 2% on the previous two losers.
Scenario 2 – The Gambling Trader
Trader B starts off exactly like Trader A and decides to also risk 1% of their account per trade. They see an opportunity in the market and plan and place their orders accordingly, also using a 1:3 risk to reward ratio. In this instance, Trader B's first attempt is a winner, giving them a 3% return. Feeling good about the results, the trader has no problem scanning the market for another trade and again finds one that fits the plan. This time, though, they decide to "play up" some of their previous winnings and place a 2% risk on the speculation; however, the market does not want to play ball and the result is a stop out. Feeling a little burned by the last trade, when another one comes along, Trader B goes back to risking the original 1%, but again is proven wrong by the market and is taken out of the trade. So with 1 winner of 3% followed by losers of 2% and then 1%, Trader B finds himself right back at breakeven after three attempts. While this is not terrible and can easily happen to any trader, it is an unnecessary outcome considering that if he has remained consistent in his risk appetite at 1%, the week would have ended up 1% overall, giving him a small profit and cover for a 4th trade the week after.
Scenario 3 – The Consistent Trader
Trader C's story is pretty simple: She has written her plan, looks for trades which match it and has decided that no matter the outcome of each trade, she will risk a consistent 1% of her account. Trade number one matched the plan, yet results in a loss of 1%. Accepting that this is the nature of the game, she finds another opportunity when it arises and risks the same 1%. Again, the trade is a loss, yet un-phased by the outcomes of her last two positions, she places her third trade of the week in the very same manner. This time the market does as she anticipated and the final profit target is reached giving a 1:3 risk to reward result and generating a 3% gain on the account. Although she has taken on two losing of 1% each, the winner gave back 3% and allowed her to enjoy a 1% return overall. Not bad for getting it wrong more than right! Encouraged by the results, Trader C sticks to her consistent risk rules and sees the power in consistent money management techniques.
Looking back on our three examples, it is important to note that each trader was not really that different from another. Their initial plan was to find trades, which matched the plan, limit the number of trades for the week to a manageable amount and stick to the rules. Though, by allowing themselves to be emotionally affected by their results, Traders A and B deviated from a well-constructed plan of action and cost themselves unnecessarily by not maintaining consistent risk. Trader C, on the other hand, did not allow her emotions to get the better of her, and graciously accepted that losses were part of the game. By allowing herself to remain objective at all times and disciplined with her money, her eventual results were by far the best, even though the hit rate was not.
Sam Evans can be contacted at The Online Trading Academy