What Are Common Risk Management Strategies for Traders?
Traders face the risk of losing money on every single trade—and even the most successful ones are almost constantly putting on losing trades. Being a winning trader over the long haul is a function of your winning percentage, and how big your wins and losses are. Regardless of how often you win, if you don't control your risk then you could end up blowing up your account.
A proper risk-management strategy is necessary to protect traders from catastrophic losses. This means determining your risk appetite, knowing your risk-reward ratio on every trade, and taking steps to protect yourself from a long-tail risk or black swan event.
Key Takeaways
- Losing money, unfortunately, is an inherent part of trading.
- The key to surviving the risks involved in trading is to minimize losses.
- Risk management in trading begins with developing a trading strategy that accounts for the win-loss percentage and the averages of the wins and losses.
- Moreover, avoiding catastrophic losses that can wipe you out completely is crucial.
- Following a rational trading strategy and keeping emotion out of trading decisions is vital to success.
Understanding Common Risk Management Strategies for Traders
There is no way to avoid risk in trading. Every single trade could, theoretically at least, end up a loser. In fact, a successful trader can lose money on trades more often than they make money—but still end up ahead in the long run if the size of their gains on winning trades far exceeds the losses on their losers. Another trader can make money on a majority of their trades, and still lose money over time by taking small gains on their winners and letting losing trades run too long.
The first key to risk management in trading is determining your trading strategy's win-loss ratio, and the average size of your wins and losses. If you know these numbers, and they add up to long-term profitability, you are well on your way to successful trading. If you don't know those numbers, you are putting your trading account at risk.
Minimizing Losses
According to legendary trader Ed Seykota, there are three rules to successful trading, and each one is "cut your losses." One common rule of thumb, particularly for day traders, is never to risk losing more than 1% of your portfolio on any single trade. That way you can suffer a string of losses—always a risk, given random distribution of results—and not do too much damage to your portfolio.
A 10% drawdown on a trading account can be overcome with a profitable trading strategy. But the bigger the drawdown, the more challenging it is to bounce back. If you lose 10% of your capital, you only need a gain of 11.1% to get to breakeven. But if you lose 50%, you'll need to double your money just to get back to even.
In addition to limiting the size of your position, one way to avoid big losses is to place automatic stop-loss orders. These will be executed once your loss reaches a certain level, saving you the difficult chore of pressing the button on a loss.
Minimizing losses is often the most vital part of any trading strategy.
Rules Keep Emotions out of Trading Decisions
Managing emotions is the most difficult part of trading. It is a truism in the trading world that a successful trader can give their system to a rookie, and the rookie will end up losing all of their money because they can't keep emotion out of the trades. That means, they can't take the losses when the trading system says get out, and they can't take the wins either—because they want to hold on for bigger gains.
That's why adopting a proven trading strategy and following the specific rules determined by that strategy are vital to success. Get into the trade when the system tells you to, and get out the same way. Don't second-guess the system.
What Are the Primary Types of Risk Management in Trading?
Risk management primarily involves minimizing potential losses without sacrificing upside potential. This is often borne out in the risk/reward ratio, a type of cost-benefit analysis based on the expected returns of an investment compared to the amount of risk taken on to earn those returns.
Hedging strategies are another type of risk management, which involves the use of offsetting positions (e.g. protective puts) that make money when the primary investment experiences losses. A third strategy is to set trading limits such as stop-losses to automatically exit positions that fall too low, or take-profit orders to capture gains.
How Is Diversification a Risk Management Strategy for Investors?
Portfolio diversification is a strategy of owning non-correlated assets so that overall risk is reduced without sacrificing expected returns. Mathematically, this combination of assets results in a portfolio that should fall close to the efficient frontier, which is elaborated on in Modern Portfolio Theory (MPT).
What Are Some Examples of Risk Mitigation?
Insurance is an example of risk mitigation. Here, a risk is taken on by some third party in return for economic compensation. So a car insurance company receives policy premiums from drivers but agrees to pay out to compensate for damage or injury incurred in a covered car accident.
In financial markets, credit default swaps (CDS) operate similarly, whereby one financial institution receives premium payments to insure another financial institution against a credit event in some other company or investment. Risk avoidance is another mitigation strategy that tries to prevent being exposed to a risk scenario completely.
