What is risk? How is it measured? Most importantly, how can it be managed? There is risk everywhere, anywhere there is an element of doubt or an opportunity, and humans are hard wired to be aware of it and try to avoid it. We are, however, more accepting of it than we think. Everyone has encountered risk in their daily lives and managed it badly; from locking yourself out of the house to stubbing your toe on the sofa, we all know the feeling of being on the wrong side of risk. The difference is, with the small risks we can weather it and build mental techniques to analyse and learn from mistakes, managing our encounters to ultimately control risk. So why is financial risk different?
The difficulty usually lies in an overwhelming lack of understanding of what financial risk is being taken on, refusing to accept a situation, and not having the ability to see it out and learn from it. Risk analysis is hard wired in daily life from birth. Connections automatically form when a child learns that a kettle is hot after touching it or how to cross a road. Over a lifetime of mental connections and subconscious analytical processes, we manage risk in such a way that we do not realise we have risk management techniques built in. We would not have got very far as a species if we could not grasp and utilise our understanding of risk. However in a market, it is not hard wired and we are not nurtured and taught from birth, mistakes happen on an individual scale all the way up to global economic scales, with each successive generation of traders. So understanding risk is essential to navigating potential disasters and to having a long and prosperous trading career.
In trading terms then, what is risk? On an individual trade level, risk is defined as the difference between an entry point and a pre-determined exit point if it backfires, in other words an entry minus stop loss. While it is possible to trade without a stop loss in place, this is akin to taking on UNLIMITED risk, if you don’t know how much risk you are taking on and cannot ride out the worst possible outcome then you will pay for your reckless approach. The history of trading is littered with starry eyed day traders who see quick profits only to fall flat on their face with greed and miscalculation. Whether it is a mental stop line or hardcoded into to a platform, a protective stop needs to be taken into account with the analysis of the trade, it frees up non-productive capital and puts a lid on stress. When you know what your risk is, it is incredibly comforting if the tides turn against you. Below are steps to utilise awareness of risk and stay trading for the long term:
- 1. Risk allocation
- 2. Risk: Reward ratio
- 3. Stop placement using TA
- 4. Minimising uncorrelated and correlated risk
1. Risk Allocation
This is split into portfolio risk, and trading account risk. Start by setting specific percentages of your overall portfolio based on time horizons and risk appetite. For a portfolio, a general rule of thumb holds that 80% should be designated for long-term investing, with the remaining 20% for short term. There is room to manoeuvre here, if you want to take on more risk you may want to slide the barriers to 75% long-term and 25% for trading. However no single trade should put an entire account at risk, the maximum percentage of risk for a trade should be between 2-3% per position.
2. Risk: Reward
When you know what your risk is from the offset only then can you sensibly calculate potential reward, the R:R ratio is an essential calculation. Quite simply it divides reward with risk. As an example, if you have a £5000 account, following the 2-3% risk allocation rule, you find a trade and place 70 pips as a stop loss, whereby if you get stopped out you will lose £150, which is 3% of your capital (0.03 x £5000=£150). It means 70 pips = £150 and that is our 3% risk. The reward is the potentially profitable portion of the trade. If we choose a 140 pips target for our trade and hit this target, we will make £300 (if 70 pips equals £150, 140 pips equals £300). This £300 profit is the reward.
So the risk: reward ratio of this trade is 150:300 = 1:2
Any trade over 1:1 is acceptable, with 1:3 being a widely accepted ratio. However a word of warning, just because a R:R is favourable does not mean you should take the trade, if you risk the same amount over 100 trades a 1:1 risk reward with a 75% win rate, is exactly equal to a 1:5 R:R with a 25% win rate. Risk: Reward however is a great barometer for calculating whether or not a trade is sensible and how much you will be risking.
3. Using technical analysis for stop placement
Technical analysis has a fantastic range of tools for entrance, exit and stop placement. Whether using the more subjective trend and support lines or retracement levels as stop guidelines or below a channel or moving average, TA provides great options. One of the most solid techniques to find a stop is Average True Range. It can be used on any time frame and factors in the true range of a period so you can avoid being stopped out unnecessarily due to market noise. The value is added to your entry position if you are short and used as a stop, or subtracted if you are long. One of the best benefits is that an ATR break is a very good indication of a market becoming erratic so if you are stopped out it will avoid unmanageable volatility and possibly a change of trend. All the while giving you enough room to stay in the game and maximise your profit run, as well as providing a solid risk level for an R:R calculation.
4. Minimising uncorrelated and correlated risk
Diversification is the best way to manage uncorrelated risk, spreading you portfolio across currencies, commodities, bonds, indexes and time frames makes sure you never have all your eggs in the same basket and softens big hits in one area. To minimise correlated risk filters are a great tool to use before making a trade to stay the “right” side of a particular market. A popular filter is only trade long if the chart is above the 200day moving average, gauging the overall health of market, so that a trade is not unduly risky. Another filter is cross checking the strength of the market, to the sector and then the stock as a long term strength test, in the same vein, when trading short term a month to week to day and intraday time frame analysis should be used to provide the directional bias for the lower time frame. Cycle analysis is very helpful when diversifying a portfolio and working out when to diversify into Bonds, Stocks and Commodities. It is essential to know that cycle follows cycle all relating to risk, when the less risky Bonds are up they will traditionally be followed by stocks and then commodities, and when Bonds turn down stocks will be next again followed by commodities and the cycle repeats.
Strategy and strength
Having confidence in your strategy is essential to letting it work, risk management allows you to test it, refine it and alter it accordingly avoiding constant tinkering with stop loss levels and emotional worry. Staying in long term requires discipline and psychological strength; accepting loses is what separates the amateurs from the professionals. Not only accepting that losses WILL occur but realising exactly when to get out is aided by understanding risk.
Consistency, consistency, consistency!
- Don’t over trade, never underestimate the importance of doing nothing, and being consistent with your rules, an unhealthy fear of not being in a trade can lead to loss of hard earned profits.
- Confusing the concepts of a winning and losing trade with good and bad trades, can be dangerous. It is possible to make money on a trade you were not sure about and lose money with a trade you calculated well, but just because this happened does not mean your strategy is wrong, it is a test of strength, with well managed risk and stop losses your strategy will be able flourish.
- Don’t trade out a loss, there is nothing worse than the scenario of holding onto a losing trade until you can’t hold on no more, having lost your shoes for that day, only to see the market creep back up to a point where you would of got your money back or worse, actually be up for the day! Sticking to your strategy and accepting your risk cuts this problem out, allowing you to be in confidently and stay in, or get stopped out and be able to accept it. Accepting loss and understanding the psychological bias against it lets the risk management work for you.
- Collect your mistakes, analyse, factor the analysis into your risk calculations and further distil your stratagem so that you are prepared and wiser.
The bottom line – Respect Risk
With a diversified strategy, trade size calculated to only expose you to 2-3%, a good Risk Reward ratio and a risk related trailing stop, you take a colossal amount of worry out for your trading. Reducing the psychological bias and enabling you to stay in the game, profit and expand confidently. Effective money management and respect for risk means you should know where you are at all times, absorb inevitable loses and leave profits running, consistently. You decide when to leave the game and continue to have a lengthy and successful trading future.