BASIC CONCEPTS AND RULES OF RISK MANAGEMENT

Risk management is maybe the most important variable of long-term trading success

Risk management is maybe the most important component of long-term trading success. This tutorial contains some basic concepts and rules of effective risk management.

 

Diversification and the 25-2% Rule

Diversification is the holy grail of financial investing. The rewards of diversifying positions in investing are far greater than an average trader can even think.

What means Diversification?

Diversification means simply not putting all your eggs in the same basket. In other words, become more diverse by mixing a wide variety of investments in the same portfolio.

The 25-2% Rule

The first percentage (25%) refers to the asset class, and the second (2%) to the individual asset, therefore:

(i) Don’t invest more than 25% of your portfolio in the same asset class (i.e. stocks, precious metals, Forex currencies, bonds, etc.)

(ii) Don’t invest more than 2% of your portfolio in a single trade position (i.e. a particular stock, a Forex pair, etc.).

Professional traders may apply strategies never risking more than 0.5% per trade.

 

Controlling the Capital Leverage

High trading-leverage results in:

(i) Increased Profit Potential

(ii) Increased Loss Potential

(iii) Increased Trade Cost

If we consider (i) and (ii) as equals, then the trader has to pay constantly a higher trading cost. If you trade intraday by applying 100:1 trading-leverage, there is a 95% probability that you will lose the entire account in 2-3 months. Professional traders avoid using more than 5:1 trading-leverage.

 

 

Risk Control by Entering Stops

Many retail traders avoid employing stops in their orders, as they fear institutional traders and brokers apply stop-hunting techniques. This may be true to some extent, but the solution is not avoiding stops, the solution is to place the right mental stops.

Employing the Right Stops

(i) In order to avoid stop-hunts, you should not place the same stops as everyone else (for example don’t place stops exactly above/below a major support/resistance level)

(ii) Empirical research shows that you must place stops at least 55 pips above/below major support/resistance levels

(iii) When employing stops, focus on the H4 chart, shorter timeframes suffer from the annoying effect of ‘market noise’

(iv) Make sure you are analyzing the market on their right chart (if you trade a Forex Cross technical analysis is probably useless in identifying stops)

(v) Seek for the master price channel and place your stops 55-70 pips above/below (Forex currencies usually trend within distinct price channels)

Positioning using Stops in Pilot Orders

Many traders place the wrong stops simply because their account cannot afford it. There is an easy way to solve that problem by using a pilot order.

Example:

Suppose you have identified a potential winning trade, and you want to risk $500 in that position, you can follow this process:

(i) Identify a Take-Profit and a Stop-Loss level

(ii) Calculate the Reward/Risk Ratio (don’t trade unless it is at least 2:1)

(iii) Open a pilot position (0.01 lot) and check how much ($) is your potential loss

(iv) Suppose your potential loss is $50, your position should not exceed 0.1 lots. Therefore, you need to open an additional 0.09 order

As simple as that you have full control of the risk and the spread you pay for each individual position.

Three Types of Stop-Loss Orders:

A stop-loss is an order that closes a position if the price of an asset reaches a certain price level. These are the most common stop-loss order types:

  • Fixed Stop-Loss
  • Dynamic Trailing Stop-Loss
  • Fixed Trailing Stop-Loss

(i) Fixed Stop-Loss

You simply place a price level at which your position will close automatically. You can modify the stop-loss level at any time.

(ii) Dynamic Trailing Stop-Loss

A dynamic trailing stop will adjust the stop-loss level every time the value of the asset moves one pip in your favor. For example, if a trader sets a -10 pips dynamic stop, and the market moves 10 pips favorable, the stop would change to zero (0) pips. The further the market moves favorably, the further the trailing stop will move, pip to pip.

(iii) Fixed Trailing Stop-Loss

A fixed trailing stop is the same as a dynamic trailing stop, except the fact it will trail in fixed increments of pips. A fixed trailing stop offers adjustment in the fixed amount of pips the stop will move. It can trail every 10 pips or 50 pips and not necessary 0.1 pip like the dynamic trailing stop.

In order to avoid stop-hunts, you should not place the same stops as everyone else (for example don’t place stops exactly above/below a major support/resistance level)

Drawdown (%) and the Risk of Losing Streaks

Drawdown is another important issue of risk management. A drawdown is the reduction (%) of our portfolio after a series of losing trades. This is calculated by measuring the difference (%) between a relative peak minus a relative trough. If an investment never lost on a trade position, the maximum drawdown would be zero. In reality, even the most successful trading systems will eventually suffer a losing streak. Risk management aims to save a portfolio after a series of losing streaks.

What is Maximum Drawdown?

Maximum drawdown is the peak-to-trough (%) decline of a portfolio during a certain period.

■ Max Drawdown = ( Peak Value – Lowest Value ) / Peak Value

Measuring drawdown and setting a maximum personal drawdown is a reasonable thing to do.

■ 10-15% max personal drawdown (pay always attention to the time period being considered)

 

 

Conclusions on Risk Management

At a glance, here are some basic concepts and rules of risk management:

-Risk management is maybe the most important variable of long-term trading success

-Diversification means becoming more diverse by mixing a wide variety of investments in the same portfolio

-The 25-2% Rule suggests not investing more than 25% of your portfolio in the same asset class and not more than 2% in a single position

-Avoid high trading-leverage (it will increase your trading risk as well as your trading cost)

-In order to avoid stop-hunts, you should not place the same stops as everyone else

-Empirical research shows that you must place stops at least 55 pips above/below major support/resistance levels

-Focus on the H4 and above charts, shorter timeframes suffer from the annoying effect of ‘market noise’

-Use pilot orders if you are not familiar with lot positioning

-Trailing-stops provide a good opportunity to expand and to secure your profits in winning trades

-Drawdown (%) is an important aspect of risk management as even the most successful trading systems will eventually suffer a losing streak

 

□ Basic Concepts and Rules of Risk Management

George Protonotarios, financial analyst

for ExpertSignal.com (c)