In this article we are going to talk about the most exciting topic of risk management!
Sarcasm aside, this is probably the single most important lesson that any trader or investor can ever learn.
Warren Buffett famously said: "Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1."
So, if it is good enough for the most successful investor of all time, it is good enough to write a post about.
Now, this quote does not apply to every single trade; no one trades without taking losses. But this is more about mindset, how to strategize, and your performance overall.
In fact, with what you are about to learn, you will see that it is actually possible to lose more trades than you win while STILL being a profitable trader.
We will get to the actual math/strategy in a moment. First, a short word about psychology.
Nothing makes a trader lose more money than not having a well thought out plan or not sticking to it.
We need to make our strategy first so that we can do it logically, and without emotion. This is easier to do beforehand because we haven’t actually put any money in the market yet.
So, what is it that we need to know?
What is my total account size?
What am I willing to lose per trade?
What is my Stop Loss?
What is my Position Size?
What is my Risk to Reward Ratio?
If you cannot answer these questions then it is not a good idea to click the “buy” button! Unless you just want to gamble and throw money away.
Question 1 - What is my total account size?
Probably the easiest question for you to answer.
Account size is the amount of money that you have in the market.
Personally, I like to split my total account size into two parts. One part for longer term HODLing. One part for short-mid term swing trading.
For my calculations, I forget about the HODL account and only look at the money in the trading account.
I personally do not day trade. If I get into a position, I expect to be in it for 1-4 weeks. Obviously, this rule is flexible based on market conditions.
Question 2 - What am I willing to lose per trade?
This one is a bit more subjective because it comes down to how risk averse you are.
It is generally accepted that you should risk between 1-5% of your account per trade.
For me, anything above 3% is higher than I like, so I stick to 1-2% and sometimes 3.
So, if you have a trading account of $10,000 and you want to risk 1%, you are risking $100:
$10,000 x .01 = $100
To be clear – Risking 1% of your account does NOT mean using 1% of your account each trade. You are not spending $100 on each trade. Risk =/= position size.
Risking 1% means that if your Stop Loss gets hit you lose $100.
Question 3 - What is my Stop Loss?
Firstly, what is a Stop Loss?
A Stop Loss is an order that is placed to automatically close you out of a position should the price be hit.
You should place your Stop Loss order right after you open your position.
This is also a good time to place another order to close out your position at your target price.
But where do you put the Stop Loss?
A Stop Loss is best placed at a price that invalidates the reason you got into the trade in the first place. Sometimes this is, very creatively, called the “Invalidation Level”.
For example, if you are trading a breakout to the upside, and then the price of your crypto shoots down in the other direction past your support levels, it is no longer a breakout and you should exit the position.
To restate this in a different way, this level should not be arbitrary. There is no reason to automatically put your Stop Loss at 6.7138%, or any other random number, of your entry.
The level you chose should be based on Technical Indicators; like a base of support, a Fibonacci level, or a previous high.
This is because the market does not care about your arbitrary values. The market is made up of people and whales (who, believe it or not, are also people), and they, the ‘Market’, care about TA.
Here is another example of a more short term trade to the downside. You could be more aggressive with the Price Target considering the resistance was so weak, but this is just an example to illustrate my point.
(MACD looks nice there too. Learn more about that HERE)
Question 4 - What is my position size?
In order to calculate position size we need to know a two different things:
Risk Per Trade - 1 to 5%
Distance from entry to the Stop Loss in percentage terms
So the equation is Position Size = (Total Trading Account Size X Risk Percentage)/Distance to Stop Loss from entry
For example, if you have a $10,000 account and you want to risk 2% while your Stop Loss is 10% away from your entry:
($10,000 X .02)/.1 = $2,000 Position Size while only risking $200.
One thing to note here is that the closer your Stop Loss is to your entry, the larger Position Size you can trade with.
So if you move the stop up to 5% away from your entry:
($10,000 X .02)/.05 = $4,000 Position Size while still only risking $200.
Naturally, a larger position gives you more potential profit. (Don’t take this to mean use margin. I personally don’t use margin for Crypto and would recommend that most people don’t either.)
Now that we have the position size, we should determine if the trade is worth getting into by finding your Risk to Reward Ratio.
Question 5 - What is My Risk to Reward Ratio?
The Risk Reward Ratio, sometimes simply known as R, is the ratio between your potential profit and potential loss.
Reward/Risk = R
So if you open a position where you can potentially lose $100, and you can potentially profit $300, then your trade has an R of 3.
If you click on the Long or Short Position button in TradingView, you can move the sliders up and down and see what your R will be in real time. Double clicking on this will take you to the settings where you can input exact values.
Since you set your Stop Loss at a logical point, one based on TA and not a whim, you should do the same with your Price Target.
So why is having a high and, more importantly, realistic R a good thing?
Because then you can actually lose MORE trades than you win and STILL be profitable.
If you know your average R you can easily calculate the minimum win rate you must have to stay profitable over the long term:
(1 / (1+R)) X 100
Let’s say your average R per trade is 2.5:
(1/(1+2.5)) X 100 = 28.5%
Meaning that you only need to win 28.5% of the time to not lose money overall.
Because of the nature of this equation as your R increases, your required winrate to stay profitable decreases.
Final Thoughts
So, now that you have asked yourself, and have answered, the five big questions you are ready to open a trade.
Remember why we do this. We should not expect to win every trade. But you must set yourself up so that when you do lose there is minimal damage to your account.
Understanding the basics of Risk Management is the tool you need to keep your losses small, and account intact.
Please let me know if you have any questions and if you like it, please hit the thumbs up and be sure to follow for more!
Links to my Fibonacci Retracement, RSI, and MACD guides are below. Give them a read for more information!
One of the cardinal rules to be a successful trader. You hit majority of the valid points. It would be great for a part 2 that goes deeper into risk management as it relates to averaging down (don't do it!) and not exiting your total position when you got your target. Sometimes letting a little percentage of your trade ride can be beneficial. Great job!!!
zsamochin
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@ishmaelf, All excellent points! My goal with this was to just cover the basics. A 2nd part would surely include getting out of only part of your position, how your R changes as the price gets closer to your targets, when to use margin (if at all), and others.
Thanks for reading!
VIP_Trading_Technologies
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Thanks for your approach into this subject. Of course everyone has its own strategy and mine is quite different: First of all I never place Stop Loss, instead I HEDGE my account totally or partially. Once you get used to this system it becomes easier to know when to enter or exit your hedges so there is no need to throw money for a "failed" entry point.
That strategy allows you to be more aggressive and therefore be more profitable.
I consider myself a Swing trader so my trade can last from few days to several weeks, till the target is reached. Will it hit my target? Sometimes no but I keep closing positions once a possible reversal is near (fibonacci helps a lot in that sense, good link too!)
Finally, I never take a trade without a clear strategy, so basically everything is thoroughly calculated and I keep trading in several stakes.
Cheers
bodozaurus
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@VIP_Trading_Technologies I like your idea about hedging. Could you share more or point us to some resources to read on more? I am a newbie and I really want to learn a lot. Thanks