gh-jamesrochabrun-skills/skills/trading-plan-generator/references/risk_management.md

# 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

1. Close ALL positions
2. Step away from computer
3. Physical activity (walk/exercise)
4. Review trades later (not now)
5. 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

1. **STOP trading immediately**
2. Take minimum 1 week break
3. Full trade review
4. Identify systematic issues
5. Paper trade only
6. 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:**

1. **Never go all-in**
   - Keep reserves
   - Opportunities come again

2. **Accept losses quickly**
   - Small losses are OK
   - Don't let small become big

3. **Don't average down**
   - Adding to losers doubles risk
   - Compounds mistakes

4. **Take breaks after losses**
   - Prevent revenge trading
   - Clear your head

5. **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:**
1. Stop trading immediately
2. Close positions if possible
3. Assess damage
4. Don't panic trade

**Flash crash:**
1. Don't chase
2. Check your stops
3. Wait for stability
4. Review risk exposure

**Account down big:**
1. STOP trading
2. Take mandatory break
3. Full review
4. 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**