A lot of traders do not have a trading plan, let alone a risk management strategy. If you do not have a trading plan, check out this article. There are deeper psychological reasons why people do not have a trading plan or adhering to their trading plans for that matter, and we are going to dig deeper in another future article.
The purposes of a solid risk management strategy are to minimise the risk of huge drawdowns and maximise a system’s profitability. When it comes to risk management, it is best to keep it simple at first. Let us begin by building the foundation. The three most crucial elements include win rate, the risk to reward ratio and risk per trade.
Everyone knows how to calculate the win rate of a strategy. Divide the number of winning trades by total trades taken, and we get the win rate. A system with a higher win rate is not necessarily more profitable. You can have a 90% win rate system with a negative risk to reward ratio. A few losing trades are all it takes to wipe out the profits made previously. On the other hand, if a system has a 50% win rate and 1:5 risk to reward ratio, it is going to be more profitable in the long run.
Here is a quick tip on how to improve your win rate. Go through your journal and analyse your past trades. Find out the similarities among the losing trades, note the criteria and never take a setup if the mentioned criteria show up again in the future. Also, find out which confluence occurs in winning trades and look for them while hunting for a setup.
Risk to Reward Ratio (RRR)
In layman terms, the risk to reward ratio is the amount we could potentially make every time we risk 1 dollar in a trade. As mentioned above, it is important to have a positive RRR. However, the optimal RRR depends on the strategy a trader is using. For instance, a smaller RRR may be more suitable for scalping since the holding period is much shorter. If the RRR is set at a big value, the market would have to move a bigger distance to hit Take Profit Level and thus decrease the overall win rate.
For swing trading, a high RRR means a home run once in a while is sufficient to cover the small losses along the way and then produce some profits.
Risk Per Trade
Risk per trade is the amount you are putting at risk every time you open a trade. We usually hear people saying to risk no more than 1 per cent on each trade. However, the optimal risk per trade depends on the traders’ risk tolerance, the win rate of a system and the holding period of trades.
If you are a risk-averse trader, determine your threshold for risk. It is also good to convert the risk % into monetary value as everyone has different account balances. You may be comfortable risking 1% on a $10,000 account but when the account is at $100,000, the numbers are way bigger and may cause psychological discomfort.
When a system has a high win rate, it is acceptable to increase the risk per trade. Why? Because you want to maximise the profitability of your system. Not only that, the risk of ruin will not have a dramatic increase if you raise your risk per trade when employing a high win rate system. For detailed calculations, you can use this [calculator] to calculate the risk of ruin of your strategy.
Lastly, it is unrealistic to risk 0.1% on a $1000 account if you plan to hold a swing trade for six months. Assuming your risk-reward is 1:20, you are only making $20 in 6 months. After commissions and swaps, how much profits do you have left?
To recap, get your system’s win rate up, employ a decent RRR and risk per trade that suits your style of trading. That way, your trading account has the best chance of growing into larger capital while generating considerable cash flow.
This article is meant to serve as a simple reference. There are always more advanced tools and calculations such as those used by high-frequency traders, quants, and financial institutions. Please do your due diligence.