9.8 KiB
Risk Management for Traders
The single most important factor determining trading success.
Why Risk Management Matters
The brutal truth:
- 90% of traders lose money
- Most blow up their accounts
- #1 reason: Poor risk management
What separates winners from losers:
- NOT better analysis
- NOT better indicators
- NOT market prediction
- Risk management and discipline
Your job as a trader:
- Protect capital FIRST
- Make money SECOND
The 1% Rule
Never risk more than 1% of account on single trade
Why 1%?
Survival math:
- 10 losses in a row = -10% drawdown
- 20 losses in a row = -20% drawdown
- Still in the game
Compare to 5% risk:
- 10 losses in a row = -50% drawdown
- Need 100% return just to break even
- Likely game over
How to Calculate
Risk Amount = Account Size × 0.01
Example:
$50,000 account × 1% = $500 max risk per trade
Position Sizing with 1% Rule
Shares = Risk Amount / (Entry - Stop)
Example:
- Account: $50,000
- Risk: $500 (1%)
- Entry: $100
- Stop: $98
- Risk per share: $2
- Position: $500 / $2 = 250 shares
Key insight: Position SIZE changes, but RISK stays constant
Daily Loss Limits
Hard stop when you hit daily loss limit
Recommended Limits
| Trader Type | Daily Loss Limit |
|---|---|
| Conservative | -1% |
| Moderate | -2% |
| Aggressive | -3% |
Why Daily Limits Matter
Prevents:
- Revenge trading
- Emotional spirals
- Blowup days
- Tilt-induced disasters
Example:
- $50,000 account
- 2% daily limit = -$1,000
- Hit limit → DONE for the day
- No exceptions
What to Do When Hit
- Close ALL positions
- Step away from computer
- Physical activity (walk/exercise)
- Review trades later (not now)
- Resume next day with clear head
Remember: There's always tomorrow
Maximum Drawdown
Stop trading at X% drawdown from peak
Recommended Limits
- Conservative: 10%
- Moderate: 15%
- Aggressive: 20%
When Hit
- STOP trading immediately
- Take minimum 1 week break
- Full trade review
- Identify systematic issues
- Paper trade only
- Return with reduced size
Why This Matters
Psychology of drawdown:
- -10% requires +11% to recover
- -20% requires +25% to recover
- -50% requires +100% to recover
Each % down becomes harder to recover
Risk:Reward Ratios
Only take trades with favorable R:R
Minimum Standards
Conservative: 3:1 Moderate: 2:1 Aggressive: 1.5:1
The Math
With 2:1 R:R, you can be profitable at 40% win rate:
10 trades:
- 4 wins × 2R = +8R
- 6 losses × 1R = -6R
- Net: +2R profit
How to Calculate
R = Risk (Entry - Stop)
Reward = Target - Entry
R:R = Reward / Risk
Example:
- Entry: $100
- Stop: $98 (Risk = $2)
- Target: $106 (Reward = $6)
- R:R = $6 / $2 = 3:1 ✓
Rule: If R:R < your minimum → SKIP THE TRADE
Position Sizing Methods
1. Fixed Dollar Risk (Recommended)
Same dollar risk every trade
Shares = Risk $ / (Entry - Stop)
Pros:
- Simple and consistent
- Easy to track
- Protects capital
Cons:
- Doesn't scale with wins/losses
2. Fixed Percentage Risk
Same % risk every trade
Shares = (Account × Risk %) / (Entry - Stop)
Pros:
- Scales with account
- Compounds wins
- Simple
Cons:
- Also compounds losses
3. Volatility-Based (ATR)
Position size based on volatility
Risk $ / (ATR × Multiplier)
Pros:
- Adapts to market conditions
- Prevents whipsaw
Cons:
- More complex
- Requires calculation
4. Kelly Criterion (Advanced)
Optimal position sizing based on edge
Kelly % = (Win Rate × Avg Win - Loss Rate × Avg Loss) / Avg Win
WARNING:
- Can be very aggressive
- Use fractional Kelly (1/4 or 1/2)
- Only for experienced traders
- Requires accurate statistics
Stop-Loss Strategies
Never Trade Without Stops
Why stops are mandatory:
- Limits losses
- Removes emotion
- Protects from disasters
- Enables risk calculation
No exceptions. Ever.
Stop-Loss Methods
1. Fixed Percentage
- X% below entry
- Simple and clear
- Example: 2% below entry
2. Technical Level
- Below support
- Below swing low
- Makes logical sense
3. ATR-Based
- 1.5-2× Average True Range
- Adapts to volatility
- Prevents whipsaw
4. Time Stop
- Exit if no progress in X days
- Frees capital
- Cuts losers
Stop-Loss Rules
✓ DO:
- Set stop BEFORE entry
- Use actual stop orders (not mental)
- Place stops at logical levels
- Honor stops always
✗ NEVER:
- Move stop further from entry
- Remove stop "just this once"
- Use mental stops
- Hope price comes back
Position Concentration
Don't put all eggs in one basket
Maximum Position Limits
Single position:
- Conservative: 10% of account
- Moderate: 20% of account
- Aggressive: 30% of account
Sector exposure:
- Maximum 30-40% in single sector
- Diversify across sectors
- Correlation matters
Total exposure:
- Day trading: 100% (close daily)
- Swing trading: 60-80%
- Position trading: Varies
Why Concentration Matters
Example:
- 50% in one position
- Stock drops 20%
- Account drops 10%
- Hard to recover
Better:
- 10% in one position
- Stock drops 20%
- Account drops 2%
- Manageable
Correlation Risk
Avoid correlated positions
Understanding Correlation
High correlation example:
- Long tech stock A
- Long tech stock B
- Both move together
- Double exposure to tech risk
Better diversification:
- Different sectors
- Different market caps
- Different strategies
- True diversification
Leverage and Margin
Leverage amplifies BOTH gains and losses
Margin Risk
2:1 Margin:
- 50% loss = margin call
- Forced liquidation
- Game over
Recommended:
- Use margin sparingly
- Never max out margin
- Maintain buffer
- Understand margin requirements
Options Leverage
Options can expire worthless
- 100% loss possible
- Time decay (theta)
- Volatility risk (vega)
- Requires different risk management
Options risk limit:
- Max 5-10% of account in options
- Treat each option as high risk
- Never bet the farm
Risk Management Checklist
Before EVERY trade:
- Position size calculated
- Risk ≤ 1% (or your limit)
- Stop-loss identified
- R:R ≥ 2:1 (or your minimum)
- Within daily loss limit
- Not overexposed to sector
- Account for correlation
- Emotionally prepared to take loss
If ANY unchecked → DON'T TAKE TRADE
Account Preservation
Capital preservation rules:
-
Never go all-in
- Keep reserves
- Opportunities come again
-
Accept losses quickly
- Small losses are OK
- Don't let small become big
-
Don't average down
- Adding to losers doubles risk
- Compounds mistakes
-
Take breaks after losses
- Prevent revenge trading
- Clear your head
-
Reduce size in drawdown
- Trade smaller when losing
- Build confidence back
Common Risk Management Mistakes
❌ Fatal Errors
1. No stop-loss Result: One trade wipes account
2. Risk too much per trade Result: Few losses = blown account
3. Moving stops Result: Invalidates risk management
4. Revenge trading Result: Emotional decisions, bigger losses
5. Averaging down Result: Doubling down on mistakes
6. Over-leveraging Result: Margin call, forced exit
7. Ignoring correlation Result: Concentrated risk in disguise
✓ Best Practices
1. Consistent position sizing Same risk every trade
2. Hard daily loss limits Stop when hit, no exceptions
3. Honest stop placement Logical levels, not wishes
4. R:R minimum Quality over quantity
5. Diversification Don't concentrate risk
6. Regular reviews Track and improve
Risk vs Reward Balance
High Probability vs High R:R
High Win Rate (60-70%)
- Smaller R:R (1.5:1)
- More trades
- Steady equity curve
- Example: Mean reversion
High R:R (3:1+)
- Lower win rate (30-40%)
- Fewer trades
- Volatile equity curve
- Example: Trend following
Both can be profitable if managed correctly
Position Sizing Examples
Example 1: Moderate Risk
Account: $50,000
Risk per trade: 1% = $500
Entry: $50
Stop: $48
Risk per share: $2
Position: $500 / $2 = 250 shares
Position value: $12,500 (25% of account)
Actual risk: $500 (1% of account)
Example 2: Tight Stop
Account: $50,000
Risk per trade: 1% = $500
Entry: $100
Stop: $99
Risk per share: $1
Position: $500 / $1 = 500 shares
Position value: $50,000 (100% of account)
Actual risk: $500 (1% of account)
Key: Position SIZE varies, but RISK stays constant
Emergency Procedures
When Things Go Wrong
Circuit breaker triggered:
- Stop trading immediately
- Close positions if possible
- Assess damage
- Don't panic trade
Flash crash:
- Don't chase
- Check your stops
- Wait for stability
- Review risk exposure
Account down big:
- STOP trading
- Take mandatory break
- Full review
- Return with smaller size
Risk Management Quotes
"Rule No. 1: Never lose money. Rule No. 2: Never forget rule No.1" - Warren Buffett
"The goal of a successful trader is to make the best trades. Money is secondary." - Alexander Elder
"Risk comes from not knowing what you're doing." - Warren Buffett
"Don't focus on making money; focus on protecting what you have." - Paul Tudor Jones
Summary
Risk management is:
- Your edge
- Your protection
- Your discipline
- Your success factor
Remember:
- Small consistent gains > Home runs
- Protect capital first
- There's always another trade
- Survive to trade tomorrow
The math is simple:
- Lose 50% → Need 100% to recover
- Lose 10% → Need 11% to recover
Trade small, trade smart, trade long-term