Risk management is one of the most important aspects in trading that gets very little attention. Judge for yourself, for every 100 books on trading you can find 1 book on risk management, for every 1000 posts on forums you can find 1 post about risk management. Most of traders think that you can simply place a stop loss order and that 's it! They think that they have a risk management system.
Usually one starts to think about risk management after the first lost deposit. But it does not last long. The next profitable trade gives us a fresh dose of dopamine which gives you a shot of self-confidence, greed, and the desire to win back not only losses, but also all the lost opportunities ASAP. Trading is, above all, an emotional process during which we are de facto under stress and often make decisions we regret later.
As Napoleon Bonaparte claimed:
"Military genius is a man who can do the average thing when everyone else around him is losing his mind."
By this he meant, first of all, that most battles are not won but lost because of ruinous mistakes. One serious mistake can undo hundreds of smart decisions that precede it. Isn't this similar to daytrading, If a single trade can lead to a total loss of the deposit? Therefore, if you are day trading, your primary objective is to preserve capital. Capital growth can only be a consequence of preserving it.
Modern trading platforms are built in such a way, that traders trade as much and as often as possible. Trading became simple! You can open a trading account in 5 minutes, and to make a trade - just in 1 click. Prices are constantly flashing in bright colors, changing and attracting attention. Brokers have designed platforms in such a way as to generate as many commissions as possible and to engage traders in active trading.
If it were up to me, I would remove one-click trading from the trading platforms. In addition, I would hide the profit/loss so they are not constantly in plain sight. Looking at floating profits/losses in an account means being under constant emotional strain. Although it is nice to see profits, we are subject to greed and the desire to close a position as soon as possible and lock in profits. As it often happens, many traders close a position much earlier than they are supposed to close.
The hardest part of trading, oddly enough, is not to trade! Don't open a position in response to a sharp move, and don't be tempted to catch up on lost opportunities. There should be no FOMO (fear of missing out) in trading. The market will present an opportunity sooner or later if you are patient.
Daytrading is very similar to the famous Stanford marshmallow experiment. In these experiments, children were offered a choice between one small marshmallow provided immediately and doubling the reward if they could wait patiently for a short period (about 15 minutes). Then the experimenter would leave the room, leaving the child alone with the marshmallow. In subsequent studies, scientists found that children who were able to wait for the double reward tended to have more prosperous lives.
In trading, more than anywhere else, the ability to be patient is needed, and a trader who knows how to wait out the best trading opportunity will not just be more successful, but he has a chance of survival.
As Jesse Livermore wrote in "Reminiscences of a Stock Operator":
"It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight!"
Trading is somewhat like hunting as performed by a jaguar. Before making a new sprint, the jaguar is able to wait for its prey for long, languid hours. When the moment is right, the jaguar sprints with swift speed, leaving the victim not the slightest chance. Then again, having rested and regained his strength, he goes into standby mode.
Such a long introduction was necessary to show the emotional component of trading and explain why the risk management is first of all the system of emotions management. It gives clear instructions to traders in order to avoid burnout and to understand how to manage your capital without getting into an emotional trap.
The suggested system of risk management is one of the models and does not pretend to be an absolute truth. The important thing is to define clear rules and principles that will give you a model of behavior in all possible scenarios.
To define your risk management system, you need to figure out your goals. What exactly is your trading goal? The goal should be specific and measurable. It should also be set for different periods of time: long term (one year), medium term (one month) and short term (one week).
- You should start by setting an annual income goal and a maximum allowable loss. To begin with, you should honestly answer the question, putting your hand on your wallet, how much money are you willing to lose in a year without significant damage to your financial condition? This would be the maximum allowable annual loss.
- The next goal is profitability. You need to answer the question, what kind of profitability are you aiming for? The profitability goal should not be excessively high. If you are dreaming of 1000% a year, you are playing with fire. On the other hand, if you plan to earn 10% a year, you should invest in low-cost index funds and ETFs that will give you that average return over the long term.
- Further, with annual goals you can easily determine monthly goals for returns and losses. For example, if your annual return goal is 100%, then your monthly goal would be 5.946%, i.e. a compound 6% per month would make 100% for the year. This can also be a figure in absolute terms, the most important is that you have a monthly profit and loss target.
- What do you do when the maximum monthly loss level is reached? You immediately close all of your positions and do not trade until the end of the month. This allows you to do a complete reset and not rush to re-enter the market. In the remaining time you can rest, restore your emotional balance, analyze your mistakes, and look for new trading opportunities next month.
- What do you do if your monthly profitability level is reached? You cut your positions immediately. This does not mean you stop trading altogether. Once the monthly profitability level is reached, you try to protect the profits as much as possible. This also allows you not to take more risk than necessary to reach your goal and not to chase higher profits.
- Next, from your monthly goals, you can roughly estimate how many transactions you need to make in a week. Here, much depends on the average percentage of your successful transactions. Let's assume that the percentage of successful transactions is about 80%, and if your goal for the month is 6%, then each week accounts for 1.5% and it will be enough for you to make 5-6 transactions. And that, in turn, implies only 1-2 deals per week. Now you understand that you do not need to press the buttons all the time! It will be enough to make 1-2 successful trades per week, and it may lead to a return of 100% for the year. At the same time, it does not mean that you have to trade every week. If the market does not provide any trading opportunities, then you need to skip it, wait for a new opportunity.
- Another advantage of this system is that by using monthly profits and losses in percentage targets, you increase your position size if you are winning, and vice versa, reduce your risk if you are losing money.
Such a risk management system helps you break your trading into periods, get a fresh start at the beginning of each month, creates guidelines for your trading, and provides psychological protection against both negative and positive trades.
This risk management system is not suitable for all traders, of course. The system should be individual, developed for you and your trading style. But the suggested system gives you an excellent example of what a risk management system could look like and why it is essential in daytrading.