Your survival as a trader depends on how you manage risk. The single most important aspect of trading is risk management.
Risk management is boring, overlooked by newbies, and ignored by the greedy. Greed without risk management will wipe out your account. The fact is traders have losses, even the most experienced traders. The difference between newbies and experienced traders is how they manage those losses.
If you are new to trading and you read only one thing on this website, then it should be this. The importance cannot be overstated.
Here’s a Fibonacci 5 risk management techniques:
1. Never ever risk more than 3-5% of equity on any one trade.
This rule ensures that with a series of 10 losses in a row a traders account will still have sufficient equity to be able to continue trading. While a series of 10 losses in a row is never expected and never a goal, it is a worst case scenario that must be considered. Would your account survive it?
2. Always use a stop loss.
What would the market have to do to prove you wrong? What is it that you think the market cannot do? Set your stop loss accordingly. Stops could be set just beyond Elliott wave invalidation points, just beyond an important prior high or low, using a trend line or a moving average.
Stop losses should be an order but may also be mental. If using a mental stop loss, the trader must have exceptional discipline to execute it at exactly the time emotion will be against you.
3. Exit a trade as soon as you recognise it has gone wrong.
Sometimes this happens before a stop loss is triggered. Sometimes market behaviour is not what you expected. This may be in terms of wave structure, volatility or anything that looks wrong. If it looks wrong and isn’t what you expected, then exit the trade promptly.
4. Don’t meet margin calls.
Experienced traders view margin calls as an objective indication that the trade has gone wrong. It it gets this bad, stop throwing good money at it!
5. Adjust position size to meet rule 1.
The importance of rule 1 cannot be overstated. Rule 5 really is a repeat of rule 1. Never ever risk more than 3-5% of your equity on any one trade. In order to keep this rule then of course a stop loss order must be used, otherwise potential risk is 100% of your equity. So really, rules 1, 2 and 5 are all the same.
When calculating equity take the value of your account minus all potential losses on all open positions. That is available equity for the next trade. Calculate 3-5% of this number and you have the amount which may be risked on the next trade.
Calculate the potential loss for a trade from the open price to the stop loss price (most trading platforms will do this for you). To keep this potential loss within 3-5% of equity adjust the size of your position.
Finally, one extra tip which is one of my personal favourites. When a position becomes reasonably profitable move your stop loss to break even or just beyond to protect a very small profit. In this way I have turned a series of potential losses into a series of tiny profits, finally getting a position that “sticks” to ride a trend. It may mean I have more tries at entering a trend than traders who can handle the pain of holding a losing trade for longer, but it does mean I sleep easier at night.
Experienced members are encouraged to add their own tips in comments below. Maybe you think there’s a really great tip I’ve not mentioned? Or maybe you think one of these tips could be said differently?
Great post Lara! I posted a comment about risk management and position sizing on another blog about a month ago. I’ll copy and paste it here. The other blog appeared to have a lot of new traders, eager to leverage up at every sign of a trade, so I wrote this to share my method of calculating position size. The traders here are more experienced but this post is relevant to yours and could help some new traders.
Here it is:
Here’s a simple equation that will determine exactly how many shares you should buy on every trade based on your account balance, entry, stop, and risk tolerance. Applying this to your entries will allow you to take your emotions out of your active positions. Using this equation alone will not ensure consistent profitability unless you have the discipline to wait for your trading setups and choose your stops carefully.
Amateur mistakes (I made them myself and I’m tempted to still make them everyday the markets are open):
At first, you will be tempted to take every trade that comes along because you’re not risking much per trade. This will eventually chew up your account and damage your confidence. You will also be tempted to pick stops closer to your entry so the math will allow you to take larger positions. This will only result in more whipsaws. You must choose a stop that price should absolutely not hit if your analysis is correct, even if it means a smaller position.
Number of Shares to Buy = (((Account Balance x Percentage Risk) – (Trade Fee x 2)) / (Entry Price – Exit Price))
Here’s an example of the math worked out if we use this data:
Account balance = 100,000.00
Percentage Risk on Account = 1%
Trade Fee (broker commissions per trade) = 7.95
Entry Price = 10.00
Exit Price (stop) = 9.50
Number of Shares to Buy = (((100,000.00 x .01) – (7.95 x 2)) / (10.00 – 9.50))
Number of Shares to Buy = (1,000.00 – 15.90) / .50
Number of Shares to Buy = 984.10 / .50
Number of Shares to Buy = 1,968
Based on this example, you’re able to put almost 20% of your account to work while only risking 1%. If you waited for one of your preferred setups and chose your stop correctly you have nothing to worry about. Place your stop and let the market take over from here because it’s going to anyways. You will sleep like a baby and never put yourself in the emotional position of hoping your losing trade makes it back to break even. Put this equation in a spreadsheet and use it before you do too much damage to your account. Over time your account will slowly grow, and so will your positions sizes, but your risk will always stay the same.
Professional traders cut their losers quickly and hope their winners trend forever.
Excellent advice Reid! Thank you for your contribution.
Thanks so much for those words of wisdom Lara. Traders ignore them at their own peril. One other surprising thing that happens to a lot traders is allowing winning trades to turn into loosing ones. Again the vice of greed is a powerful driver of this common mistake. I try to avoid this by ALWAYS having a reasonable profit target when I enter a trade. In this market environment, it is smart to never leave money on the table! 🙂
That’s another good point Verne.
My exit technique is to exit on a target, or if the target isn’t hit to exit when a trend line that consistently provided support / resistance during the trend is breached.