Mastering Risk Management
Losing traders think about how much they will make on a trade. Profitable traders obsess over how much they can lose. There are an unlimited number of ways to win as a trader. There is only one way to lose. Understanding and mastering risk management is the only way to ensure that you can become a profitable trader.
Risk management matters because it helps you protect your winners, compound your gains, and avoid blowing up your account. Without proper risk management you will always give back your gains, you will never consistently lock in profit, and you won't become a winning trader.
How Risk Management Works:
Now that we know why risk management is so important we can focus on understanding how risk management works. Risk management is a proactive, not a reactive process. Nothing can make you feel better in a trade once you are already in. You remove those anxieties by building strong, consistent, repeatable habits that you can rely on.
At its core, risk management is described as how much money you can lose per trade. As traders we do not want our risk management to be random. It is impossible to find consistency in our process if we always have inconsistent wins and losses.
Each risk management strategy is dependent on the individual trader. Everyone has a different tolerance for risk and different number that breaks them psychologically. However, the more times you can afford to lose, the higher probability you have at making it as a trader.
Personally, I never risk more than 1% of my account per trade (after stop loss). That means it should take me 100 consecutive losing trades for me to blow up my account. Trading is a challenging game and each individual setup will require me to think differently about my risk management. For some trades a fifty-cent move could be 1% of my account and others it could be a fifty-dollar move. Managing risk is a constant process and it must be considered for every single trade.
There are two main components to a successful risk management strategy:
- Using Stop Losses
- Your Position Sizing
Using Stop Losses
A stop loss is the point at which you admit that your idea, timing, or trade was wrong. Once your stop loss is triggered you close your position and accept the loss. Good trading is about compounding positive decisions and not compounding negative decisions. Therefore, it is extremely important that traders respect their stop losses and do not let their trades escalate past that point. Admitting you are wrong is never fun, but it is a key part of becoming a successful trader.
Your Position Sizing
Your position sizing directly contributes to how much you make or lose per trade. A 10% loss is different for a $1000 and $100 trade. Therefore, it is important that we understand how to size our trades for each play. Each trade will be unique and will require different stop loss amounts or percentages. Therefore, we must adjust our position sizing based on what that risk actually is. We don't want to trade a setup that requires a fifty-cent or fifty-dollar stop loss the same.
How to Manage Risk
Effective risk management is about understanding that trading should be turned into a very simple numbers game. If you are able to keep your losing trades consistent, becoming a profitable trader becomes a simple equation. (Win Rate X Risk Reward) = Profit
A trader with a 20% win rate (is profitable on 1 out of 5 trades) becomes a profitable trader overall if they target a 10 - 1 risk reward ratio. That means on average you make 10 dollars for every 1 dollar risked. So even if you are correct only 2 out of 10 times you still double your money.
The only way day traders are able to take advantage of this simple equation is if they learn how to effectively manage their risk. As you learned earlier, risk management is made up of two core elements. It is your stop loss and your position sizing. Those two elements must be working in sync if you are to keep trading a numbers game.
Your objective is to always make sure you respect the setup for what it is. Some trades need different stop losses than others. We cannot treat every trade as having equal risk. Therefore, we must understand and define that risk and then use our position sizing to ensure we keep trading a numbers game.
My objective is to make sure I never lose more than 1% of my account per trade. Therefore, I need to adjust my position sizing based on what the required stop loss is. A full-size play is 10% of my account. If your account is $10,000 then your largest position should be $1,000. 10% of $1,000 = $100. $100 = 1% of $10,000
Day Trading Math
Unfortunately, there is a little bit of math involved when it comes to day trading. But it is simple, repeatable, and you just need to understand how to apply it before plugging it into your calculator. Our objective is to calculate how much the option contract will sell off if we are wrong. Then we can use the position sizing guideline from the previous chapter to size our positions appropriately. To determine the stop loss percentage
How big the stop loss is on the underlying security
The delta of the option contract
The price of the option contract
We get the delta and price from the option chain while the stop loss is always taken from the underlying security. For example. If we were trading AAPL options we would use the AAPL stock chart to determine our stop loss, take profit, and risk reward calculations. In general the stop loss is the difference between the low of our setup candle and the entry target, but more on that later.
For now all we need to know is how big that number is. Your stop loss in cents or dollars will be different for every single trade and you must do the calculation before every single trade. Some trades will require a stop loss of thirty-four cents while others will require a three dollar and forty cent stop loss. The formula to determine the position size for those two different trades will be identical each time with different variables for each trade.
If you recall from the options basics chapter, delta is the measurement of how much the option price moves for every 1 dollar that the stock moves. We use that information to help us estimate how much the contract will sell off if we are wrong.
Every trade will require you to define your stop loss size, know the delta of your contract, and how much each contract costs. Those numbers will be different for every single trade but how you plug them in will always be the same.
The Formula is:
(stop loss X delta) / option price = stop loss %
For Example:
The stop loss is $0.67, the delta of the 305 contracts is 0.45 and the option costs $2.25 a contract.
So...
stop loss = 0.67
delta = 0.45
price = 2.25
Formula =
(0.67 X 0.45) / 2.25 = 0.134
Your stop loss would be 13.4% and your position sizing would 2/3 of your maximum position size.
Let's do another
stop loss = 0.31
delta = 0.24
price = 1.15
Formula =
(0.31 X 0.24) / 1.15 = 0.065
Your stop loss would be 6.4% and you would be going with your full position size on this play.
And One More
stop loss = 5.67
delta = 0.35
price = 12.50
Formula =
(5.67 X 0.35) / 12.50 = 0.158
Your stop loss would be 15.8% and you would round up to a 20% stop loss and go half of your full position size.