This is a Guest Post by Niclas Hummel, creator of the Risk Simulator and a trader living in Bangkok.
“Trading is managing risk and being a trader is being a risk manager.”
This simple statement implies two realities:
- There is always risk
- The only thing you can do is manage it
So what can you do to be a better risk manager?
1. Understanding Leverage
Wait… more risk? The question one should ask here is: Why can you just easily sign in to a CFD or Futures Broker and be offered to trade with 20 times the money that you have deposited?
The answer lies in the incentive of the broker. He wants you to trade as much as possible with the highest leverage possible because it generates the most commission. He doesn’t care about your risk! You have to take care of it.
Leverage is a double-edged sword. It increases profit potential but also loss potential. The thing that lures people into high-leverage brokers is the wrong mindset about risk. This mindset forgets, that with more reward comes more risk. Often people don’t understand this simple fact. They think that it is good to trade low volatility forex pairs, such as the Pound against Dollar with high leverage. Basically, this is only true for the broker, because commissions generated in Forex are amongst the highest in the industry.
What the brokers want is not what you want
Have you ever noticed that the margin requirements to open a position change during the day? Yes, that’s because brokers calculate margin requirements based on volatility! The more margin they offer you, the less volatile is the underlying. Low volatility = less opportunities. They want you to trade markets with high risk of being stopped out in less volatile markets, equaling more commissions.
You as a trader and risk taker have to resist luring yourself into this cheap mindset and start to realize what risk is really about and how it correlates with volatility.
2. Recognizing the “Uncomfortable Effect”
You might have the feeling of getting stopped out far too often by the “invisible hand of the market”.
This has to do with what I call the “uncomfortable effect”. Most people who buy into the market like to feel comfortable. It is really comfortable clicking the “BUY” -or “SELL”-button without waiting for a setup. That’s the one side of the extreme. The other side is getting into the market when everything lines up, when the trend is already crystal clear, and 5 indicators scream “BUY”. Risk is often high in comfortable situations like these.
The market is a reflection of human emotions; therefore traders often fall into the mistake of trading too comfortable. The least risk is often in the uncomfortable situations, that most people don’t feel comfortable taking.
3. Avoid Overtrading
Overtrading is a big risk as a discretionary trader. It is one of the reasons why people prefer using algorithms over discretion. But if you can manage this “Over-Behavior” you’re in a good place to make it as a trader.
The reason that I see why many traders overtrade is because they want to make back previous losses and find themselves in an endless spiral of another trade, and another trade, which is also a sign that these traders are in fact only gamblers putting money into a slot machine.
Think of the broker like a casino owner. You don’t want to be the gambler inside the casino that eventually wins sometimes and then gives it all back, you want to be the owner of your own casino, by playing the market as a casino.
An edge, which is basically managing risks effectively (and must be suitable to your own personality, time and market) lets you take the risks that are “uncomfortable” to others somewhere in between of too much and not enough “lining up” for a trade. With such an edge, you are the casino, playing the other market participants emotions.
4. Respect Market Correlation
Markets can be highly correlated. You can check some correlations at www.investing.com. There is always a strong correlation between Dow Jones and Dax for example. There is a correlation between Oil and commodity-pegged currencies such as the Canadian Dollar. So, if you’re ever taking more than one trade at a time you should respect the correlation risk in your position sizing.
5. Respect Emotional Correlation
Also called serial correlation, because it means that one trade has a correlation to the previous trade. This is a problem for most traders without realizing it. It comes into effect because you often cling to the emotions of the previous trade. You want to immediately make back your losses by throwing in another trade or getting euphoric about winning and having too light a mindset for the next trade.
The only way to combat emotional correlation is to be conscious about your emotions before, during and after the trade. You can write an emotion-diary and watch patterns, eexample “Whenever I feel confident, my trades tend to not work out.” Another trick is to count down before the next trade, forcing you to bring your prefrontal cortex back in the decision making process.
6. Stop “Drawdown Steepening”
Emotional and market Correlation risks are two of what I call “hidden risks”. Another one is the drawdown steepening curve, which means that the farther the drawdown, the more intense the emotional battle becomes which results in worse decision making. Dealing with drawdowns is the hardest part of being a trader.
Whenever you find yourself in these drawdowns, remember that you have already calculated that this can happen.
Take a break and regain objectivity, sometimes taking a small walk outside or waiting for the next day or even a week to relax is a good way to not increase your risk of losing more in a losing streak.
With all that said, all you basically have to work towards as a trader is avoiding the mentioned pitfalls and finding good risk/reward opportunities and letting them play out. There are always two ways to improve in this regard:
7. Increasing Winning%
Winning more trades and loosing less is a never-ending learning field for any risk manager. The most effective way of improving this ratio is to cut out trades that…
- …are based only on emotions
- …are based on too few or too many reasons
How to cut out these trades?
Journaling everything that you do as a trader helps a lot. By journaling I mean writing down the reasons for an entry and exit, but also the emotions that you have during, before and after a trade, like I mentioned before. A good way to do journaling for traders involves also filming the session with a screen recorder.
When you have a significant number of trades journaled, you can look back at what you’ve done and see the points where you can improve and trades that you can avoid going forward.
9. Increasing Risk/Reward Ratio
Risk is not everything in the equation. The question is always what you get from taking a certain amount of risk. Good examples of a bad risk/reward ratio are: playing the lottery (obviously), binary options and scalping systems. Not to say that certain scalping systems don’t work. It’s just that you need a crazy high amount of winning% and even the best traders usually don’t win more than 50% of their trades.
Letting winners run
Your brain loves instant gratification. This is the biggest reason why you might exit too early. Counter your brain and let winners run! Trust me, this is the best way to increase risk/reward ratio. With risk/reward ratio I will take into account average losing$ vs average winning$ not profit/loss on a single trade basis. As an active trader you will probably have around 200-1000 trades per year. So it’s all about…
A good way to increase Risk/Reward ratio is by focusing on managing the initial risk (The risk that you first have when entering a trade with a stoploss) more effectively on every one of the thousand trades that you will take in the future. This results in decreasing the average losing$. Trailing the stop with a Simple Moving Average is a good way to decrease average losing$ and therefore increasing R/R ratio. Some of the best stock traders I know use this simple technique.
Going back to journaling, if you have written down every exit condition, you can find out which exit technique will increase your overall profit by creating a what-if simulation in excel. Try 13, 20, 50 EMA / SMA Trailing for example and see if you are overall more profitable applying these rules.
Having these statistics in mind, you can apply them next time with good conviction that you improved yourself as a risk manager.
10. Using Monte Carlo Simulation
Knowing your average losing$, average winning$ and winrate%, you can use a Monte Carlo simulation to project the equity curve in the future. Use my Risk Simulator and find out your equity curve possibilities and other metrics.
The simulation can help you convince yourself, that what you’re currently doing is the right thing and shouldn’t be changed.
It can get you a realistic sense of what the maximum drawdown and losing streak can be, so that you can expect it and deal with it objectively. You can also play around with the numbers to see what is profitable and what is not.
The more stable the equity curve projection, the better the risk management.
Risk of Ruin
This is another number to consider. It basically means the risk of blowing up your account, defined by a certain drawdown% (50% I consider blowing up). Risk of loss per trade should by no means be more than 1% each over 1000 trades, because you will likely reach that trade number over your lifespan and you don’t want to have a bigger of ruining your trading account.
You can know your risk of ruin if you go down under the graph of the Risk Simulator and watch at the expected drawdown field, next to where Profit Factor, Expectancy etc. is shown.
I’m glad you have read to the end of this article and I’m happy if you received useful information, that could help you to be a better risk manager.
Niclas Hummel teaches traders how to understand risk on a professional level. He created the Risk Simulator to give the trading community a tool, that is useful for anyone who uses a trading system.