A Few Thoughts on Risk Management I've Learned from Top Traders
If you speak to any experienced traders who have been around financial markets for long enough, they will ALL tell you that Risk Management is their #1 focus when trading. More so than what they’re trading, when they’re trading, or the potential profit that’s on offer. The first thing they think about is, “What’s my exit strategy for this trade?”
"The essence of investment management is the management of risks, not the management of returns." Peter Bernstein, Bernstein-Macaulay Inc
Novice traders often overlook the significance of risk management, leading to catastrophic consequences for their trading accounts, and a short-lived trading career. The allure of quick profits glamorised by the FURU Twitter crowd can overshadow the potential risks of trading, exposing traders to excessive drawdowns and capital erosion.
Falling in (strictly plutonic) love with risk management is essential for several reasons:
1. Capital Preservation: Preserving your trading capital is paramount to ensure that you have the resources to participate in future generational trading opportunities (think COVID, GFC, Dot Com Crash). These are the events that experienced traders are happy to basically tread water (usually making conservative, consistent profits along the way) and lie in wait for years, ensuring they’re ready to deploy capital once true panic/fear, or greed emerges. By limiting the size of individual trades and employing effective risk management, you protect your capital from significant losses, allowing you to recover and trade another day.
2. Emotional Discipline: Trading with real money evokes strong emotions, especially during periods of market volatility. Having effective risk management fosters emotional discipline, preventing impulsive decisions and guiding traders to adhere to their trading plans.
3. Long-Term Sustainability: I’ve been trading highly leveraged CFD’s for over 20 years now. The vast majority of traders come and go, usually only lasting a few years before they’re never heard of again. Sustainable trading success is rooted in consistent and controlled risk-taking. Implementing risk management strategies cultivates a long-term perspective, promoting steady growth and mitigating the adverse impact of occasional losing trades (ie Drawdowns).
"Large losses are forever - in investing, in teenage driving, and in fidelity. If you avoid large losses with a strong defence, the winnings will have every opportunity to take care of themselves." Charles Ellis, Greenwich Associates
On average, the S&P 500 has experienced a market correction of at least 10% roughly once every 19 months since 1928. Fair to say, as a trader you need to be prepared for these types of moves!
Some Basic Risk Management Strategies:
1. Position Sizing: In my experience of trading leveraged financial products, this is the big one. Position sizing involves determining the appropriate amount of capital to allocate to a specific trade. By executing on a consistent and calculated position sizing strategy, such as risking only a small percentage (e.g., 1% to 3%) of your trading capital on any given trade, you minimise the impact of potential losses and ensure capital preservation. Knowing when to increase position sizing in tandem with a high conviction setup is where the top guys excel.
2. Setting Stop-Loss Orders: Stop-loss orders are pre-defined price levels at which a trade will automatically be closed to limit losses. Placing stop-loss orders at strategic points based on technical analysis, historical analysis or volatility assessments protects your capital from excessive drawdowns and prevents emotional decision-making.
3. Diversification: Diversifying your trading portfolio across different assets and market segments can mitigate risks associated with specific assets or sectors. By spreading your capital among various trades on markets that are generally not well correlated, you reduce the impact of adverse movements in any single asset. For example, Bonds and SPX, Gold and SPX, Commodities and USD etc.
“If you can’t stomach 50% declines in your investment you will get the mediocre returns you deserve” Charlie Munger, Berkshire Hathaway
4. Risk-Reward Ratio: Assessing the risk-reward ratio before entering a trade is crucial. Aim to identify trades with a favourable risk-reward ratio, where the potential reward outweighs the potential risk. A positive risk-reward ratio allows you to profit even if not all trades are successful.
Advanced Risk Management Techniques
Leverage Management: While leverage can amplify profits, it also magnifies losses. Responsible leverage management involves using leverage judiciously, understanding its impact on your trades, and ensuring it aligns with your risk tolerance and trading strategy.
Conditional Orders: Conditional orders such as Limit Orders, Stop Entry Orders, or Trailing stop-loss orders which adjust automatically with price movements. This dynamic approach to risk management adapts to market changes, offering a balance between capital protection and profit maximisation.
EXAMPLE:
Let’s take a real-life example from last Friday the 19th January on the SPX.
Without going into detail, I had a 90%+ confidence going into the Euro open (6pm AEST) that the SPX would finish higher (Expected Average Move +39pts), based on similar historical setups. SPX futures were trading at +10pts at the time, so while there was a compelling R/R opportunity for a LONG trade, that still meant that there was a 10% chance of a large loss in the absence of any risk management. And what if the market fell 50pts intra-day before recovering? Did I have the stomach and capital to withstand that?
The other complicating factor is that I need the maximum possible amount of beauty sleep for obvious reasons, so I never stay up past about 9pm. This means that conditional orders are critical for my international trading.
I was happy to go LONG at Euro open, and add to my position each 5 pts below this price. But how do I decide where and when to place my stops?
In this case I know that >95% of all meaningful rallies on Fridays will bottom prior to RTH open (1am AEST), so I placed my ‘Buy’ limit orders manually (4786, 4781, 4777 etc), and ran a very simple EA on MT4 over the top of this (see below) which removed anyb outstanding limits order, and placed stops on any open trades at 5pts below the low of the 6pm-1am trading period.
In this case it obviously worked well. I had two entries, and the stop (placed ~4780 at 1am) was not threatened. The key here is that if we did get falls, my potential losses were controlled.
Stress Testing Your Portfolio: If you’re a swing or longer term trader, regularly stress-testing your portfolio against hypothetical market scenarios (like significant downturns) helps in understanding how your trades would perform under extreme conditions. This practice can guide you in fine-tuning your strategies to withstand volatility. If I had done this in 2022 with my leveraged LONG index positions, I would have realised I was significantly over-levered in the case of a market pullback, and saved myself from complete account liquidation.
"Risk comes from not knowing what you're doing." Warren Buffet, Berkshire Hathaway
Psychological Aspect of Risk Management
Maintaining Trading Psychology: A trader's mindset can be as important as their strategy. Maintaining a level head, staying patient, and not succumbing to emotions like fear and greed are critical aspects of successful risk management (easier said than done). Regular self-assessment, Ice Baths, Saunas, Meditations…whatever you’re into can help in stabilising your trading psychology.
Technology in Risk Management
Utilising Trading Tools and Software: Advanced trading platforms and software offer various tools for risk analysis and management. If you’re clever, you can write algo’s for use in various programs like Pro Real-Time, or MT4. I’m a dummy, so I use Chat GPT to convert the kind of order and trade conditions I want into code, which I then turn into EAs (Expert Advisors), which execute on the MT4 platform (you can set an MT4 account up through most CFD brokers). Utilise these tools to monitor market conditions, set automated alerts, conditional orders, and track your exposure to risks in real-time.
In summary, the best of the best are obsessed with AVOIDING large losses, and making sure that they’re always actively limiting their downside exposure.
As I’ve said before, the win rate on my accounts when I’ve traded publicly is <40%! Pretty horrible right?? However, I managed large returns on those accounts due to controlling the size of my losses. Don’t be afraid to take a loss! They are a critical part of trading….but make sure you know what that loss looks like, before you even start.
Cheers
Marto