3 Steps to Manage Risk But Not Reduce Return
There is a simple rule of thumb you need to abide by as a trader. Win big, lose small.
It seems simple enough however the concept of winning big for many traders translates into them risking more which inevitably puts their account at risk.
Here are 3 simple steps to reduce risk but not reduce return.
Step 1. Every position you take in the market you should have a pre-determined price level where you are going to exit the trade. What is your worst-case scenario and what % of your account does that represent? This is a must so you can maintain consistency on your losing positions and you do not experience a major drawdown.
Most successful investors and traders who have stock portfolios and may also trade other markets such as FX will generally not allow a single trade to draw down their account by more than 2%. For example, if their account is $25,000, they will not allow one trade to draw their account down by more than $500. They will exit when they are down $500. By setting a maximum risk limit on individual trades such as 2% you know specifically what your worst-case scenario is.
When you set a risk limit you must then work out how much volume to take on the trade to ensure you do not exceed your 2% but at the same time the volume traded allows you to place your stop loss in an appropriate place in the market. At Trading Mastery you will be using a spreadsheet to calculate these numbers before you enter a trade.
Step 2. Don’t attempt to hit a home run on every trade. Don’t think that every trade you need to stay in the trade for a major move. Provided you are consistent in how you take profit and you are consistently staying in trades to ensure you make more than you lose on average you will likely steadily improve your performance over time.
The great thing about setting a risk limit is that you have limited your down side but you have not limited your upside. Your upside is open and can be as large as you allow it. It is important that you understand price action in the market you are trading and where a logical place to take profit is.
Step 3. Know what your risk to reward ratio is. This number is a tell-tale sign to whether or not you are going to survive and prosper as a trader.
Let me share with you an example of a series of trades so you can immediately open your statement and work out your risk reward ratio. Your risk to reward ratio is your #1 barometer and here at Trading Mastery every trader is given a spreadsheet to punch in their trade results and it automatically calculates their risk reward ratio so they know what it is at all times.
Following is an example of a risk reward ratio for a trader over their first two months.
They take 10 trades.?
They win 6 and lose 4.
Their winning trade profits were as follows. $950, $800, $650, $700, $690, $595
Their losses on each losing trade were as follows. $510, $495, $487, $501.
Their average winning trade is $730.83.
Their average losing trade is $498.25
Their risk to reward ratio is currently 1.46. ($730/$498)
Your risk reward ratio must be as high as you can get it and must never fall below 1.0 because if it does it means you are losing on average more than you are winning and you will eventually drain your account.
You should be aiming to get your risk reward ratio to above 2.0. If you can achieve this over a number of years you will be making outstanding profits.