How to Manage Your Risk

No trading system will be profitable long term without the right risk management.

In the twenty-first century it has become fashionable to manage one’s own investments, yet few traders implement disciplined, professional money management strategies. During the stock market Dotcom bubble, limiting risk was an afterthought, but after the 2008-2009 meltdown, it showed many investors and traders that it was time to get serious about the management of their money and showed the risk that even conservative investment positions were exposed to. Professional risk and money management strategies are the foundation for success with any trading strategy. Essentially, money management tells you how many shares or contracts to trade on any given position.

For example, money management tells you whether you have enough new money to trade additional positions. Don’t confuse money management with stop placement. Stop placement does not address the how much question. Your stop shows you where the price has to go for you to exit your position but the position sizing aspect of your money management parameters will determine how much you lose if your stop loss is triggered and you exit your trade.

Money management is risk management. Risk management is the difference between success and failure in trading. Trading correctly is 90% money and portfolio management. Unfortunately, this is a fact that most people want to avoid or don’t understand. Once you have your money management under control, your discipline and psychology is 100% of your success.

Money management optimizes capital usage. Few have the ability to view their portfolios as a whole. Even fewer traders and investors make the move from a defensive or reactive view of risk, in which they measure risk to avoid losses, to an offensive or proactive posture in which risks are actively managed for a more efficient use of capital. Trend following risk management formulas and philosophies are key to increasing profits while controlling risk.

Here are some questions you must answer about your own money management and bet sizing:

  • How much capital will you place on each trade? What will be your percent of total trading capital on one position?
  • What will be the maximum portfolio heat on your trading? How much could your account go down in one day? How much total risk exposure do you have?
  • Capital preservation versus capital appreciation. How much are you willing to risk in the pursuit of profits?
  • When must you take a loss to avoid larger losses? Your stop loss that results in a small loss is your insurance policy against large losses.
  • If you are on a losing streak do you trade the same? Do you decrease your trade size during losing streaks?
  • How must you prepare if trading both long and short positions? What are your signals for the long or short side?
  • Does a portfolio of long and short allow one to trade more positions? How do they correlate for total risk exposure?
  • How will your trading be adjusted with accumulated new profits? Do you trade bigger positions as your account grows? Will you have a system for withdrawing profits or will you leave your profits in your account and compound your gains?
  • How is volatility handled? What filters for volatility will you use to adjust your position size and stop losses?
  • How do you prepare yourself psychologically? How will you manage the stress and excitement of trading to maintain your trading discipline?
  • Have you tested your bet sizing? What size of drawdown do you expect during a losing streak based on your win percentage and potential losing streak?

Money management will dictate decisions to trade the same number of contracts or shares in all markets. Precise formulas set forth size. A trader who uses a constant trading size gives up an important edge in much the same way a blackjack player does when always betting the same regardless of what cards are on the table. Common single contract/share measures of trading system performance such as win/loss ratio, percent winning trades, etc. are of little value to decision-making when using trend following systems (and the turtle system). Often the best trading approach, when tested on a single contract/share basis, will turn out not to be the best approach when money management strategies are incorporated.

Short term trading is not, by definition, less risky. Some people may mistakenly apply a cause and effect relationship between using a long term strategy and the potential of incurring large loss. They forget profit and loss are proportional. A short term system will never allow you to be in the trend long enough to achieve large profits. You end up with small losses but also small profits. Added together, numerous small losses equal a big loss. When you trade for the long term, you have a more positive expectation in terms of the size of the move. In the big picture of a market trend, the larger the move then the larger the validation of the move. If you were trading some short term pattern predictive system you would never be able to participate fully in the big trends. Big trends make the big profits.

All systems have drawdowns. You can’t have a profitable methodology, without taking some calculated risks as well as some losses. Trend following drawdowns are a function of the risk level desired. Risk level among trend followers varies depending upon the size of the profit they seek. For example, if you sought 100%+ a year gains you must be prepared for the possibility of a 30% drawdown. Anyone who promises you can make 100%+ with only the possibility of a 5% drawdown is lying.

Required margin has little to do with money management considerations. For example, if the margin was dropped from $5000 to $2500 on a particular stock or commodity, must you trade twice as many shares or contracts? Of course you do not, margin issues are not money management.

Slippage is not a major concern for a trend trader’s money management. No one wants bad fills. But trend following for the long term places far less emphasis on perfect fills for success. In contrast, short term traders’ transaction costs and skids on their fills affect their bottom line to a much greater degree.

The win/loss ratio is not as crucial to trend traders as it is to most other types of traders. Trend trading can experience many small losses in a row. Trend trading systems (like the legendary turtle system) trade for the outsized large move. Several big trends a year are your key to success. The strategy cuts your losing positions quickly. Consequently, a few big trades will make up the bulk of your profits and many small trades will make up your losses. Winning trades can range from 35-50%, but that percentage reveals little information since we expect more losses (of smaller value) than winners (of much larger value). Win/loss ratio, while a favorite of the novice trader, has limited use in terms of trend trading analysis.


Trend trading tips:

  • Manage your position size when you trade.
  • Adjust your position sizing based on volatility
  • Know where you will get out before you get in.
  • Set your stop losses where your trade entry is invalidated not based on a percentage.
  • Manage your trades so your losses are small.