Tuesday, January 01, 2019

Risk Management Techniques For Consistent Trading Profitability

Managing risk is the primary job of a trader, you have heard this a million times. But this not enough. This part of your trading system, managing risks is completely devoid of any glamour and excitement.  That is why it gets easily sidetracked in favour of finding great entries. The allure of different technical tools and indicators proves too much for the beginner and they lose focus so I will state it again, but a bit differently...

Managing risk is the ONLY job of a trader. - Dean
Photo by Lubo Minar on Unsplash

How to manage risk in trading? (Traditional Approach)

So how exactly do we manage the risk in trading? There are multiple ways in which you can accomplish that, let's look at a few of them.

1. Using a money stop or per cent stop or fixed risk per trade...

This is the simplest and that is why probably the most preferred way to managing risks for the beginners. It is very easy to do the math, in case someone is not very inclined towards it. Let's look at an example of a typical account...

Capital - INR 100,000
Max Risk On All Open Positions - 4% of capital = INR 4000
Max Risk Per Trade - 2% of capital = INR 2000
Max Loss Per Month - 10% of capital = INR 10,000

So if you have 4 positions open, and you get each one of them wrong you cannot lose more than INR 4000. Also, if you use a 2% stop on any one of your positions the rest of your positions have to contend with only the remaining 2% of the limit.

Now, this is not a bad plan to manage risk. Like if you hit the 10% loss mark for the month you stop trading, come back next month and take a fresh view on the markets. It all sounds great if you can stick to the plan...

2. Variable risk based on account profitability...

every trader looks at the accumulated profits differently. Some may treat it as a part of their original capital, some may treat it as free money to take much more risk against as compared to their original capital.

Whatever way you look at it, adding some variability to your risk management plan based on the quantum of profits you make is a great strategy. I personally use a simple variation of this. These are my numbers...

Risk Per Trade - 0.25% of capital (some may find this very conservative, but this is the way I like it.)
Max Risk On All Open Positions - 2% of capital
Max Loss Per Month - 4% of capital

This is how I can sleep at the end of the day. This might be different for different traders. Then I vary my risk per trade based on the amount of profit I make for the month, the numbers stack up as below...

Profits Risk
Up to 1% 0.25%
2% +  0.50%
3% + 1.00%
4% + 2.00%
5% + 4.00%
6% + 4.00%

This was with accumulated profits I can risk more and more, consequently increasing my profits if I get my trades right. But if I lose and fall back below the prior slabs I will cut my risks in the same proportions. let me give you some numbers...

If I make 2% profits on one of my trades at the start of the month, I will increase my initial risk on the next trade to 0.5%. Suppose I make another 2% now my initial risk on my next trade will be 2% of capital. This time I don't get so lucky and lose the 2% risk amount. I am still roughly up by 2% for the month so my corresponding risk will be again just 0.5% until I make additional profits.

Numerous permutations and combinations possible...

One can make a zillion combinations suiting each traders personality and requirements. But if what we discussed so far sounds interesting to you, then you need to read on. Now I will reveal how I look at risk and how it is fundamentally different from these more traditional approaches...

How to manage risk in trading? (My Approach)

Well first and foremost I don't look at the risks in terms of percentage or money risked per trade, I look at risk in terms of probabilities associated with my positions. let me explain this one in detail...

Let's say I am having a bullish view on the markets and markets are moving up until they hit a resistance zone. Now some supply is expected to come in when we near a resistance, but what matters most is how the auction reacts to this supply. 

If it absorbs the supply then we can say that buyers are strong and may take out the resistance. If on the other hand, the prices move away from the resistance quickly it may tell us otherwise. In the latter case, sellers have the upper hand.

So instead of calculating the risk per trade (which I do keep within prescribed limits), I focus more on the risk associated with holding a long, short or flat position in the markets. If the buyers are doing a poor job, I won't stay in or take short positions, however attractive the reward to risk ratio is.

Where the beginners get it wrong...

This is where most beginners get it wrong, in the hopes of multifold profits, they end up ignoring the real risk. The risk of holding a position in the given market conditions. If you can sniff out the odds of holding a given position in the present market conditions, then you may actually be on to the holy grail of trading.

How do you manage the risks in your positions?

This is where the tools you use for analysing the markets come in. I am not pushing my favourite tools viz Market Profile or VSA, but these are probably the best ones to assess the risk in holding a certain position in the markets.

But you can use your favourite tool, just tweak the way you look at the markets. The indicators and tools are not there to tell you when to enter a position, but to tell you when to stay away from the markets.

Let's look at an example...


As seen from the above chart, if you were looking for a short entry, you got one, when the value started developing lower today. But if you were asking what was the risk of holding a long or a short position in this kind of markets, you would have reached a different conclusion.

let me elaborate a bit...

  • Holding a long was not a very good idea because of os the exhaustion of the buyers (inability to take out the clustered highs zone). 
  • Secondly, today's lower prices and value lacked on the very important thing, trade facilitation (repeated range extensions to the downside and an elongated profile shape).
  • Combine this with the PL in I period today, followed by an inside-bar in J period, the downside momentum was pathetic, which resulted in a sharp pullback.
based on the above three points it can be concluded fairly easily that, the risk in holding or creating a short position today was very high. Even though an inventory adjustment break was likely. The final nail in the coffin was the I period PL and J period inside-bar.

The Market Profile terminology may be a bit too much to digest for the newbies, but I think the point to prove here is about the risk of holding a short position.


The possibilities are endless if you could just tweak your point of view a little bit. If you can master this art of looking at risk in a completely different light, your trading can change a lot in a short period of time.

I hope my way of risk management made sense to you, and I am quite certain your friends and colleagues will like it too. So go on and share it with your friends and colleagues because...

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