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Planning and risk management

LESSON 5 OF 8

Ways to manage risk: part two

1 What is a trading plan? We've looked at some general methods of managing your risk,
7 MIN now here are two practical techniques you can use to work out
How to make a trading … exactly how much risk you should be taking on with each trade.
2 10 MIN
3 What is risk manageme… Calculate your maximum risk per trade
6 MIN
Choosing how much to risk per trade is all about your personal
4 Ways
7 MIN
to manage risk: p… circumstances. You'll find some guidance that says don't risk more
than 1% of your trading capital per trade, while others say it's ok to
5 Ways
7 MIN
to manage risk: p… go up to 10%. Most traders agree not to go much higher than that
though, and here's why...
6 Choosing
3 MIN
your trading …
If you go on a big losing streak, the amount you're risking per
7 Position and swing tradi… trade will have a huge effect on your capital and the ability to claw
10 MIN back your losses. Say you've got $10,000 of trading capital and
Day trading and scalping you're unlucky enough to lose 15 trades in a row. Here's the
8 10 MIN difference between risking 2%, 5% or 10% per trade:
Quiz
10 QUESTIONS
 With 2% risk per trade, even after 15 losses you've
lost less than 25% of your trading capital. It's
conceivable that you can win this money back.
However, if you'd gone for 5% risk per trade,
you'd have lost over half your initial trading
capital. You'd have to more than double this
amount to get to your original level.
With 10% risk per trade, things are even worse.
You'd be down over 75% making it extremely
difficult to make back the money you've lost.
The reduction of capital after a series of losing trades is called a
drawdown. It's important to work out what percentage drawdown
will make it difficult to reach your trading goals, and then ensure
your maximum risk per trade is in line with that.
Based on this information, you can also work out a risk-per-trade
scale. If you're an active trader who only places a few trades every
day/week, then the scale might look like this:
Of course, if you're a long-term investor only making a few select
share trades per year, then 10% risk per trade might make
complete sense. But if you're a high-frequency forex trader
making over a hundred transactions per day, then even 2% per
trade could be far too high. It all depends on you and how you like
to trade.
Remember, all traders will be affected by a losing streak at some
stage, but the ones who plan their trading to cope with those
streaks are usually more successful in the long run.
Work out the risk vs reward ratio of every trade
It is possible to lose more times than you win, yet be consistently
profitable. It's all down to risk vs reward.
To find the ratio on a particular trade, simply compare the amount
of money you're risking to the potential gain. So if your maximum
potential loss on a trade is $200 and the maximum potential gain
is $600, then the risk vs reward ratio is 1:3.
If, for example, you placed ten trades with this ratio and you were
successful on just three of those trades, your profit and loss
figures might look like this:
Over ten trades you could have made $400, despite only being
right 30% of the time. That's why many traders like to stick to a
risk/reward ratio of 1:3 or better.
A word of warning though – if you're taking on less risk for a
greater potential reward, it's likely the market will have to move
further in your favour to reach your maximum profit, than it will to
hit your maximum loss.
So, in the above example, the market would probably have to
move three times as far in your favour to reach a $600 profit, than
it would have to move against you to cause a $200 loss.
Question
Say you buy 100 shares of Citigroup at $27
each, but you don't want to risk more than
$400. At which price should you place your
guaranteed stop loss?
 Correct
As you've
purchased 100
shares, if the
price of
A $31 Citigroup drops
$1 you stand to
B $27.40 lose $100. To

make sure you
C $26.60 don't lose more
than $400 you
D $23 need to place
your
guaranteed
stop loss $4
below the
current price at
$23.

Lesson summary
Always calculate your maximum risk per
trade:
Generally, risking under 2% of your
total trading capital per trade is
considered sensible
Anything over 5% is usually
considered high risk
Work out the risk vs reward ratio of
every trade:
It is possible to lose more times
h i b i l
 than you win, yet be consistently
profitable
Many traders like to stick to a
risk/reward ratio of 1:3 or better

Lesson complete
Ways to manage risk: part one
LESSON 4 OF 8
Choosing your trading style
LESSON 6 OF 8

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