Valuable Risk Management Strategies For Trading
[Reprinted with permission of Profit Buddies]
Risk Management is an activity we all engage in; from wearing our seatbelt to homeowners insurance, we’re trying to control some form of risk. But what about the risks associated with trading and investing? In this article we’re going to discuss a few key Risk Management techniques.
As mentioned above, Risk Management is an activity or activities we use to reduce or control some form of risk. In trading or investing, the simplest definition of risk is “losing money”. So what can we do to reduce our risk? There are many articles, studies, books, etc, covering nearly every aspect of Risk Management, but let’s limit our scope to traders.
- Never trade with money you need. “Money you need”? Is there such a thing as money we don’t need? Actually, yes… money you need includes money used to pay for essentials (food, clothing, and shelter), to buy gas, pay bills, money to save for emergencies and retirement, whatever you “need” to survive and thrive. Everything else is money you don’t “need”, usually described as “discretionary” or “disposable”. The risk we’re mitigating is not losing the money we “need” for more important purposes.
- Never risk all of your money on one trade. As the old proverb states; “never place all of your eggs in one basket”, some very sage advice for a saying that has been around forever. The risk here is pretty simple… if you risk it all and lose; you’re out of the game. Even if you win… and win big… the next time you bet it all and lose, you’re out of the game. As a trader you will at some point hear the saying; “the longer you stay in the game, the better your chances of winning”, again, some very sage advice.
- Keep your position sizes relatively equal. Doing this ensures that one position in your portfolio doesn’t overpower any other. If you have $100.00 and place 4 bets of $25.00 each, and one of those bets loses 25%, your account will be down a total of only about 6%. If, on the other hand, you have $100.00 and place 3 bets of $20.00 and one bet of $40.00, and the $40.00 bet loses 25%, your account will be down 10%… nearly double the total loss to your portfolio!
- Diversify your positions. As with all investing and trading, diversification is a must. Much like the previous two bullets, diversifying protects us from catastrophic loss of our capital if, for example, some company were to go bankrupt. This subject is so crucial to our financial well-being, I plan on publishing a complete article on this subject in the near future.
- Account Allocation. Account allocation means how to allocate the funds in your portfolio, such as how much to allocate for trading and investing, how much to keep in reserve, how many positions to have open, etc. I’ll try to touch on each of these topics below;
– Allocation. Much like keeping some extra cash for emergencies in a savings account, or not running a checking account balance down to zero, it’s generally a good idea to not invest all of your trading funds. These extra funds could allow for unforeseen fees or commissions charged by a broker, minimum account limits, and such.
– Reserve. Reserve is the amount of trading funds kept aside for future trading use. These reserve funds are meant for new position opportunities that may arise, and can also help fund new trades after taking a loss on a previous position.
– Number of Positions. There are two main concepts here; number of positions, and maximum number of positions.
— The number of positions open at any one time is a great way of controlling risk. As market conditions provide higher probabilities of success, more trades could be opened, if market conditions change, fewer open positions reduce your funds at risk.
— Knowing the maximum number of positions you may have open at any one time allows you to properly allocate your trading funds using the above activities. If you don’t know the maximum number of positions you will have open, it will be difficult to determine how much to allocate per trade, how much to keep in reserve, or even how much of your portfolio is at risk at any one time.
- Fixed Fractional Allocation. Although I gave this item a bullet of its own, it’s really another approach to Account Allocation. In this approach, a specific percentage of your trading capital is allocated to every new trade… say 25%. Using this approach, position allocations grow as your trading funds increase (after winning trades), and position allocations shrink as your trading funds decrease (after losing trades), all while keeping your position allocation at 25% of your trading funds. The intent of this approach is to play more dollars on the way up, yet keep investors/traders “in the game” longer by decreasing risk during losing streaks.
While we’ve covered a lot of information in this article, there is always more to learn about Risk Management; your job is to continue learning, continue earning, and try to apply some of the above concepts in your investing.
Discuss this article and other investing topics at Profit Buddies
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