As briefly highlighted in part one, the staple behind any respectable trading plan will place a strong emphasis on risk and money management principles.
What is your overall market risk?
Overall market risk is the maximum permissible amount of capital at risk at any one time.
As an example, let’s say that we have set our overall market risk to not exceed 4% of our total account equity. If we have two open trades each risking 2%, taking additional trades would not permitted. What about if one of the trades has risk reduced to breakeven though? Good question! Technically speaking, risk is not reduced until your positions have been liquidated. Be that as it may, unless a major event triggers that causes the market to gap, breakeven stops will generally be honoured. For that reason, opening another trade at 2% risk is acceptable.
Each and every time one interacts with the market, a stop-loss order SHOULD be used. This is what helps contain your risk. Mental stops sound great in theory, but in reality the market can, and sometimes does, move in the blink of an eye. To a high degree, using a mental stop would place you in an incredibly exposed position and this is not something we would ever support.
While the stop value should ALWAYS adhere to your maximum permissible risk (see above), it should equally be positioned as and where your strategy dictates. For instance, if you trade supply and demand and you’ve just executed a buy order at the top edge of a demand base, stop-loss orders, assuming this is what your trading method instructs, should be located a few pips beneath the zone and calculated to respect your risk model.
To determine the risk-reward (r/r) ratio of a strategy, one also has to identify the win/loss ratio. To show why is best demonstrated with an example:
Suppose a strategy’s r/r is, on average, 5:1, which basically means a gain of 100 pips is achieved while only risking 20 pips. In isolation, you’d be hard pressed to find a trader on the planet pass on these stats. Nevertheless, what if this strategy only manages to achieve these gains 15-20% of the time? Although still likely a marginally profitable method, it certainly doesn’t boast the appeal it once did! Therefore, we can see that without the win/loss ration taken into consideration, it’s impossible to fully comprehend a strategy’s potential.
To assess the win/loss ratio of a trading strategy, one must first define their method. Once you have a large enough sample size of trades, you can then determine its win/loss probability. As an example, assume that the sample size came back with a 40/60% win/loss ratio. What this means is that 40% of the trades came in as winners, while 60% were losers i.e. a probability of success of 40%. Now assume that on those winning trades, on average, price achieves two times its risk (2:1 r/r). Hypothetically speaking, lets say a person over ten trades, has $10,000 in their account and risks 3% on each trade. This would then net a gain of $600 before transaction costs (300 [risk] * 6 = 1800 [losses] / 300 * 2 600 [gain] * 4 = 2400 [2400 – 1800 = 600])
The bottom line here is to ensure that your method has a positive expectancy!
Knowing when enough is enough
Having the discipline to know when to stop trading for the day is, at least in our book, considered extremely good risk management. It helps avoid revenge trading (an emotional response to recover losses) and also helps curb greed. For that reason, it might be an idea to incorporate the following rules:
- Profitable trading day – target achieved. Sign off and shut down the computer.
- Maximum permissible daily loss of 2% – stop trading and shut down the computer.
- In the event that there are no setups, trying to create one is always risky. In this case, it’s best to sign off and do something else.
Should your computer malfunction whilst in a trade or your internet suddenly trips out, do you have a plan in place? As we all know, these things usually happen when you least need them to!
An easy way to overcome this is have an additional back-up internet connection and invest in a mini portable generator. In addition to this, always have the telephone contact details of your broker nearby.
Trading capital should be money that you CAN afford to lose, PERIOD. If you wipe out the account, it should make very little difference to your current standard of living.
In the event of a large drawdown, what plan do you have to help manage this? A trading plan should always include a cut-off point. As an example, if your overall account equity drops below 25%, all trading should seize and you should not commence trading again until you have recognized the reason(s) behind the drawdown.
Having set your overall market exposure (risk segment above), the size of your position should NEVER surpass this value. Being disciplined and sticking to your noted risk parameters is crucial. It doesn’t matter how much conviction you have in a particular setup, it CAN still fail and yield a loss. Position sizing, therefore, is a vital component that deserves the utmost respect. To make life easy, we recommend using a position sizing calculator.
We hope we have done enough here to highlight the importance of risk and money management principles. Failing to observe these rules will, we can almost guarantee it, lead to stress, frustration and inevitably a depleted account.
In part three, we’ll be turning our attention to trading strategies, market selection and trading times, all of which have an important place in one’s trading plan.