JS-Masterclass: Risk Management #1
Risk Management in Trading – What does it mean ???
Risk management in trading is following a set of principles for minimizing losses. It’s an essential part of a trading plan that helps to minimize the losses and capture sustainable profits.
One of the biggest mistakes traders make is focusing on maximizing profits while overlooking the potential for loss. Unfortunately, that’s the best way for losses to get out of control. Traders need to leave this notion of greed behind them and always think risk first. Once a trader has mastered this principle, the successes will follow.
Implementing risk management techniques into your trading strategy can mitigate your risk when the market moves in the opposite direction.
Fundamental risk management principles for minimizing losses
Whether you are new in trading or an experienced trader, you always need to consider the following principles. They need to be a central part of your trading plan and strategy.
The 1% rule
The 1% rule in trading is a crucial principle of position sizing. It refers to risking no more than 1% (absolute max. for pro-traders is 2%) of your capital on a single trade.
For instance, if you have $50,000 in your account, applying the 1% rule would mean you won’t risk more than $500 on a single trade.
Some traders use the 2% rule to increase potential profits, but that amplifies potential losses, too. Sticking to the 1% rule will limit your risk on any given trade and help you preserve your equity. New traders should start with even lower risk levels.
Stop-Losses
Stop-loss orders are sell orders that trigger automatically when a traded security’s price reaches a lower, pre-specified price. They can help you mitigate losses on trades that don’t pan out the way you hoped.
For instance, if you buy a particular stock at $32 per share, you could put a stop-loss order at $30 to close the trade if the price drops below $30 per share.
Amateur traders should work with stop loss orders that will automatically trigger when your pre-defined stop-loss is being hit. This avoids a mistake that every trader tends to do – go in with a stop-loss plan but then deviate from it when things go against you.
Using stop-loss orders is key to having complete control over your positions, particularly when engaging in day trading.
The risk/reward ratio
The risk/reward ratio is a measure for calculating expected returns for every dollar you risk on a particular trade. For instance, if your risk/reward ratio is 1:2, you could earn $20 for every 10 dollar you risk.
It’s crucial to calculate the ratio after you’ve decided on your stop-loss and take-profit orders. If the ratio doesn’t match your requirements, you need to wait for a more profitable trade.
Here’s how to calculate your risk/reward ratio:
RRR = (Entry price – Stop-Loss) / (Profit Target – Entry price)
If dividing the potential risk with the possible reward results in a value below 1.0, your potential profit is more significant than your potential loss.
Make sure you maintain a favorable risk/reward ratio and look for ways to improve it consistently. IN order to be able to do that, you need to have a trading log book.
The Batting Average
The Batting Average helps you compare your winning and losing trades. Dividing your total number of wins by the total number of trades will help you analyze your past performance and identify areas for improvement. A ratio above 0.5 (or 50%) shows your trading strategy is working.
Suppose you had 60 winning trades and 40 losing trades. Your Batting Average is 60%, which means you have more winners than loosers.
Combining your Batting Average with your risk/reward ratio will help you manage potential losses more effectively.
Here is a table which helps you better understand the relationship between the risk/reward ratio and the Batting Average:
The table shows that you should have a minimum batting average or 40% or better. Many traders would consider themselves as so called ’2:1’-traders. This means they always try to have a profit of their winners at least 2x their pre-defined risk (stop-loss). As you can see in the table, ‘2:1’-traders have built in failure in their trading strategy as they can be wrong more often than right and still make tons of money – a ‘2:1’-trader can be incredibly successful at a batting average of only 40%. This means the ‘2:1’-trader can only have 4 winners out of 10 trades and still be highly successful.
Risk Management in Trading – What does it mean ???
Risk management in trading is following a set of principles for minimizing losses. It’s an essential part of a trading plan that helps to minimize the losses and capture sustainable profits.
One of the biggest mistakes traders make is focusing on maximizing profits while overlooking the potential for loss. Unfortunately, that’s the best way for losses to get out of control. Traders need to leave this notion of greed behind them and always think risk first. Once a trader has mastered this principle, the successes will follow.
Implementing risk management techniques into your trading strategy can mitigate your risk when the market moves in the opposite direction.
Fundamental risk management principles for minimizing losses
Whether you are new in trading or an experienced trader, you always need to consider the following principles. They need to be a central part of your trading plan and strategy.
The 1% rule
The 1% rule in trading is a crucial principle of position sizing. It refers to risking no more than 1% (absolute max. for pro-traders is 2%) of your capital on a single trade.
For instance, if you have $50,000 in your account, applying the 1% rule would mean you won’t risk more than $500 on a single trade.
Some traders use the 2% rule to increase potential profits, but that amplifies potential losses, too. Sticking to the 1% rule will limit your risk on any given trade and help you preserve your equity. New traders should start with even lower risk levels.
Stop-Losses
Stop-loss orders are sell orders that trigger automatically when a traded security’s price reaches a lower, pre-specified price. They can help you mitigate losses on trades that don’t pan out the way you hoped.
For instance, if you buy a particular stock at $32 per share, you could put a stop-loss order at $30 to close the trade if the price drops below $30 per share.
Amateur traders should work with stop loss orders that will automatically trigger when your pre-defined stop-loss is being hit. This avoids a mistake that every trader tends to do – go in with a stop-loss plan but then deviate from it when things go against you.
Using stop-loss orders is key to having complete control over your positions, particularly when engaging in day trading.
The risk/reward ratio
The risk/reward ratio is a measure for calculating expected returns for every dollar you risk on a particular trade. For instance, if your risk/reward ratio is 1:2, you could earn $20 for every 10 dollar you risk.
It’s crucial to calculate the ratio after you’ve decided on your stop-loss and take-profit orders. If the ratio doesn’t match your requirements, you need to wait for a more profitable trade.
Here’s how to calculate your risk/reward ratio:
RRR = (Entry price – Stop-Loss) / (Profit Target – Entry price)
If dividing the potential risk with the possible reward results in a value below 1.0, your potential profit is more significant than your potential loss.
Make sure you maintain a favorable risk/reward ratio and look for ways to improve it consistently. IN order to be able to do that, you need to have a trading log book.
The Batting Average
The Batting Average helps you compare your winning and losing trades. Dividing your total number of wins by the total number of trades will help you analyze your past performance and identify areas for improvement. A ratio above 0.5 (or 50%) shows your trading strategy is working.
Suppose you had 60 winning trades and 40 losing trades. Your Batting Average is 60%, which means you have more winners than loosers.
Combining your Batting Average with your risk/reward ratio will help you manage potential losses more effectively.
Here is a table which helps you better understand the relationship between the risk/reward ratio and the Batting Average:
The table shows that you should have a minimum batting average or 40% or better. Many traders would consider themselves as so called ’2:1’-traders. This means they always try to have a profit of their winners at least 2x their pre-defined risk (stop-loss). As you can see in the table, ‘2:1’-traders have built in failure in their trading strategy as they can be wrong more often than right and still make tons of money – a ‘2:1’-trader can be incredibly successful at a batting average of only 40%. This means the ‘2:1’-trader can only have 4 winners out of 10 trades and still be highly successful.
Combing the BEST of two WORLD's: Cathie Wood & Mark Minervini