What is Riskmanagement?
"Trading is managing risk and being a trader is being a risk manager."
This simple statement implies two realities:
There is always risk and the only thing you can do is manage it.
The whole engagement in buying and selling derivatives and equities involves taking risks, because risk is the price of opportunity.”
Derivatives such as Futures and CFD’s offer leverage. It basically means you’re able to borrow the broker money to gain access to more risk. Wait, more risk? The question one should ask here is why can you just easily sign in to a CFD Broker and being offered to trade with 20 times the money that you have deposited?
The answer lies in the incentives of the broker. He wants you to trade as much as possible with the highest leverage possible because it generates the most commission. He doesn’t care about your risk! You, yourself have to take care of it.
Leverage is a double-edged sword. It increases profit potential but also loss potential. The thing that lures people into high-leverage brokers is the wrong mindset about risk. This mindset forgets, that with more reward comes more risk. Often people don’t understand this simple fact. They think that it is good to trade low volatility forex pairs, such as the Pound against Dollar with high leverage. Basically, this is only true for the broker, because commissions generated in Forex are amongst the highest in the industry.
What the brokers want is not what you want
Have you ever noticed that the margin requirements to open a position change during the day? Yes, that’s because brokers calculate margin requirements based on volatility! The more margin they offer you, the less volatile is the underlying. Low volatility = less opportunities. They want you to trade markets with high risk, because you’re getting stopped out more often in less volatile markets aka more commissions.
You as a trader and risk taker have to resist luring yourself into this cheap mindset and start to realize what risk is about.
As a trading beginner you often don’t understand risk. You think that trading is easy. You forget, that on the other side of the trade there are banks, hedge funds etc. who hire the best people they can find on the market place to manage their risks. They have advanced mathematical models at their hand, which all specialize on one thing: managing risk in the most effective way. Therefore, what can you do to play somewhat on the same level? Of course, learn about statistics, analyze the markets at least in some professional way that comes closer to the analysis of finance professionals.
Getting stopped out too often
Sometimes as traders you develop the feeling getting stopped out far too often by the magic hand of the market. This has to do with what I call the “uncomfortable effect”. Most people who buy into the market as a risk taker likes to feel comfortable. One thing that is comfortable is just clicking the buy/sell button without waiting for a setup, this is the one side of the extreme. The other side is getting into the market when everything lines up, when the trend is already crystal clear, and 5 indicators scream “BUY”. Risk is often high in comfortable situations like these. The market is a reflection of human emotions; therefore traders often fall into the mistake of trading too comfortable. The least risk is often in the uncomfortable situations, that most people don’t feel comfortable taking.
Overtrading is a big risk as a discretionary trader. It is one of the reasons that people prefer using algorithms over discretion. But if you can manage this “over-behavior” you’re in a good place to make it as a day trader. The reason that I see why many day traders overtrade is because they want to make back previous losses and find themselves in an endless spiral of another trade, and another trade, which is also a sign that these traders are in fact only gamblers putting money into a slot machine.
Think of the broker like a casino owner, you don’t want to be the gambler inside the casino that eventually wins sometimes and then gives back, you want to be the owner of your own casino, by playing the market AS a casino. An edge, which can solely come from managing risks effectively, that is suitable to your own personality, time and market and lets you take the risks that are “uncomfortable” to others somewhere in between of too much and not enough reasons for a trade is needed to be the casino.
Markets can be highly correlated. Some Forex correlation you can check here at investing.com. There is always a strong correlation between Dow Jones and Dax for example. There is a correlation between Oil and commodity-pegged currencies such as Canadian Dollar. So, if you’re ever taking more than one trade at a time you should respect this in your decision making.
Also called serial correlation, because it means that one trade has a correlation to the previous trade. This is a problem for day traders many times because they often cling to the emotions of the previous trade. They want to immediately make back their losses by throwing in another trade or getting euphoric about winning and having a too light mindset then for the next trade. Read my article about 5 mindset tricks for day traders to learn about dealing with this correlation, that increases risk in most day traders accounts.
Emotional and Market Correlation risks are two of what I call “hidden risks”. Another one is the “drawdown steepening curve”, which means that the farther the drawdown, the more intense the emotional battle becomes which results in worse decisions. Dealing with drawdowns is the hardest part of being a day trader, especially managing the negative emotions coming out of this during the day. Whenever you find yourself in these drawdowns, remember that you have already calculated that this can happen. Take a break and regain objectivity, sometimes taking a small walk outside or waiting for the next day or even a week to relax is a good way to not increase your risk in a losing streak.
With all that said, all you basically have to work towards as a trader is finding good risk/reward opportunities and letting them play out.
There are always two ways to improve in this regard:
Winning more trades and loosing less is a never-ending learning field for a trader/risk manager. The most effective way of improving this ratio is to cut out trades that have:
Poor reasons why to execute them
Trades based only on revenge or hope
How to cut out these trades? Journaling everything that you do as a trader helps a lot. By journaling I mean writing down the reasons for an entry and exit, but also the emotions that you have during, before and after a trade. A good way to do journaling for day traders involves also filming the session with a screen recorder (A powersoft) When you have a significant number of trades journaled, you can look back at what you’ve done and see the points where you can improve and trades that you can avoid the next time.
Increasing Risk/Reward Ratio:
Risk is not everything in the equation. The question is always what you get from taking a certain amount of risk. Good examples of a bad risk/reward ratio are: playing the lottery, binary options and scalping systems.
Not to say that certain scalping systems don’t work. It’s just that you need a crazy high amount of winning% and even the best traders usually don’t win more than 50-70% of their trades.
Our brain loves instant gratification. This is the biggest reason why people exit trades too early. Counter your brain and let winners run! Trust me, this is the best way to increase risk/reward ratio.
With risk/reward, I mean the ratio between average loosing$ vs average winning$. It’s not on a single trade basis. As a day trader, doing 1-20 trades per day, you will for sure have about 300-1000 or more trades per year.
Therefore, a good way to increase this ratio is by focusing on managing the initial risk (the risk that you first have when entering a trade with a stoploss) more effectively, which results in decreasing the average losing$. Trailing the stop at a Simple Moving Average is a good way to decrease average loosing$. Some of the best stock traders I know use this simple technique.
Going back to journaling, if you have written down every exit condition, you can find out what trailing technique would increase your overall profit by creating a what-if simulation in excel. Try 13, 20, 50 EMA / SMA Trailing on close or breach and see if you are overall more profitable. Having these statistics in mind you can apply it next time with good conviction that you improved yourself as a risk manager.
Monte Carlo Simulation
Knowing your average loosing$, average wining$ and winrate%, you can use monte carlo simulation to project the equity curve in the future. You can try the Risk Simulator here.
The simulation can help to convince yourself that what you’re currently doing is the right thing and shouldn’t be changed. It can get you a realistic sense of what can be the maximum drawdown and loosing streak, so that you can expect it and deal with it objectively. You can also play around with the numbers to see what is profitable and what is not. The more stable the curve, the better.