This article is the continuation of our previous article “Risk Management-I“. Please consider reading that before going further.
In the previous article. We have learnt some of the basics of Money Management. We also learnt about some basic Risk Management tools like stop-loss, trailing stop-loss, position sizing etc. In this article let’s discuss more interesting Risk Management topics.
Controlling Overall Exposure
Overall exposure refers to the part of total capital that a trader is willing to risk across all the potential trading opportunities that are in front of him/her. Risking the entire existing capital in the account could be dangerous if every single trade fails. At the same time, risking only 1% of capital mitigates the risk of losing the entire capital, but the resulting profits are extremely minimal. The fraction of capital you are willing to trade depends upon the returns expected from the portfolio. Simply put, the higher the expected returns, the greater the recommended level of capital.
One more relevant factor is the correlation between the existing securities in the portfolio. Two securities are considered to be positively correlated if a change in one security is accompanied by a similar change in the other. Similarly, two securities are considered as negatively correlated if a change in one security results in an opposite change in the other.
Generally, the higher the positive correlation across the securities in a portfolio, the lower the overall exposure level. This safeguards against multiple losses on positively correlated securities. By the same logic, higher the negative correlation between securities in a portfolio, higher the recommended overall optimal exposure.
The overall exposure of the capital could be a fixed fraction of available funds. Alternatively, the exposure fraction may go up and down along with the changes in the trading account balance. For example, an aggressive trader might want to increase overall exposure when he sees a decrease in his account balance, while a defensive trader might be more conservative and choose to increase the overall exposure only after witnessing an increase in his account balance.
As there is an old saying which suggests us not to keep all the eggs in one basket, it is dangerous to expose a vast chunk of your capital when you trade, especially when you are sceptical about it. It is recommended to wisely allocate the risk capital in the order of your most favourable trades. It can be tough to control the overall exposure when you trade on margin, as the rewards are really tempting. But those are the times you should be extra careful in exposing your capital wisely with emotional and financial discipline.
Allocating Risk Capital
Once the trader decides the total amount of capital that he/she is willing to risk for trading, the next step would be allocating this amount across competing trades. The easiest way to do this is to allocate an equal amount of risk capital to each decided trade. This simple approach is specifically helpful when the trader is unable to estimate the reward and risk potential of a trade. However, the unspoken assumption here is that all the trades represent equally good investment opportunities. A trader who is uncomfortable with this way of allocating Risk Capital can follow a different allocation procedure by:
- Identifying the trade potential differences
- Translating these differences into corresponding differences in risk capital allocation.
Differences in trade potential are measured in terms of the probability of success and the RRR (Risk to Reward Ratio) for the trade. This can be calculated by dividing the expected profit by the maximum permissible loss or the payoff ratio, which is calculated by dividing the average profit earned on completed trades by the average loss incurred. Higher the probability of success, greater is the part of the capital that could be exposed to the trade.
In general, many successful traders take a lot of time in calculating the permissible risk capital as it defines the degree of profit or loss that incurs in a trade. You should be thoughtful while you do this because if you allocate a large amount of risk capital in a single margin trade, you may lose your entire capital. On the flip side, if you do not utilise a decent fraction of your capital on trades with huge potential, you are limiting your profits to very minimal amounts whereas you could have made more money if your risk capital was in line to the potentiality of the trade.
Consequences of Trading Unbalanced Risk
An unbalanced risk equation arises when the risk assessment for a trade and the trader’s ability and willingness to assume risk are not on the same lines. If the risk assessed by a trader on a trade is higher than that permitted by the resources he/she has, we have a case of over-trading. On the other hand, if the risk assessed on a trade is lesser than that permitted by the resources of the trader, he/she is said to be under-trading.
The situation of Overtrading occurs if the risk assessed is higher than the permitted resource of the trader, and it is particularly dangerous. It should be avoided, as it threatens to rob the trader’s precious trading capital. Overtrading typically arises from a trader’s overconfidence about his next move. When he is totally convinced that his judgement is absolutely right over the next trade which he is willing to take by subsequent events, no risk seems too big for his bankroll. There is nothing that can stop him from taking that trade irrespective of the amount of capital which is at risk! This is a typical case of emotions winning over facts. Here the unreasonable risk-taking can quickly convert into gambling, with disastrous consequences. Yes, when there is an unbalanced risk along with the greed to make more profits, it is nothing but gambling.
Under trading is an indication of extreme caution. It does not hamper the trader’s capital, but it does put a damper on the trader’s performance. This can cause fear and paralyse the trader to trade anything further. When a trader fails to stretch himself as much as he or she should, his or her performance falls short of optimal levels. This can and should be avoided.
Both Over-trading and Under-trading are the result of trading with unbalanced risk. This has all the capabilities to stop you from becoming a successful trader. As they always say, the best trades are the ones where the risk is balanced and not the ones that just yield a lot of uncertain profits.
Assessing the Magnitude of Loss
The dollar value of a loss entirely depends on the size of the bet or the fraction of capital, which is exposed to trading. As exposure increases, the scope of profits also increases relatively. They are directly proportional. Assessing the magnitude of the loss is quintessential when you margin trade. An example will help us to dramatise the double-edged nature of the leverage sword and what happens if you fail to assess the loss. This will not only give you an understanding of evaluating the magnitude of the loss but also you will realise how brutal it can be if the assessment goes wrong.
In August 2001, a trader with $200,000 in his account understood that the stock market is overpriced and is due for a significant correction. He then decides to use his entire capital to short-sell futures contracts on the Standard and Poor’s (S&P) 500 index, which at that time is trading at 541.30. Since he is extremely sure about the market correction that is about to happen, he decides on the initial margin requirement as $20,000 per contract and decides to sell ten contracts of the December S&P 500 index on 25th August 2001, at 541.30. On 19th October 2001, in the wake of Black Monday as expected he executes his short positions at 401.30 for a profit of $70,000 per contract which amounts to $700,000 on ten contracts! This story has a beautiful ending, illustrating the power of leverage.
Now let’s consider the flip side of a trader failing to assess the Magnitude of Loss.
Fast forward to December 2017; A Crypto enthusiast wanted to leverage trade Bitcoin when its price was at ~$19,800. On 17th December he observes the price of Bitcoin and does the fundamental analysis. After the analysis, he believes Bitcoin has way more potential and is still underpriced. Firmly believing in that, he doesn’t even consider the scenario of losing the trade. So, he continues to long Bitcoin with 50x leverage on 17th December 2018. To his surprise the very next day, the Bitcoin crash occurs, and the price of the Bitcoin falls from $19.8k to under $11k. Hence, however sure you may be about a trade, it is essential to follow robust risk management techniques and assess the magnitude of a loss. You never know what might go wrong and when.
Especially in the highly volatile markets like Forex and cryptos, where the prices are affected by simple news events, it is crucial to assess the risk before investing or trading. And using leverage is definitely risky as it is a double-edged sword. The returns look incredibly tempting for a fraction of the capital you are risking, but the trade gets extremely risky. One wrong step in assessing the loss that you could incur can get your account liquidated. So it is better to determine the magnitude of the loss for every single trade you take.
The Risk to Reward Ratio
RRR, AKA The Risk to Reward Ratio, is an essential metric in trading and a trader with a clear understanding of RRR can improve his chances of becoming profitable. The risk to reward ratio in trading is basically the relationship between the size of your stop loss to the size of your target profit.
For instance, if your stop-loss is ten pips away from the price of your entry and your profit target is 20 pips away from the entry, then your risk to reward ratio is considered as 1:2. The general advice is that you shouldn’t be taking trades unless there is at least 1:1 or 1:2 RRR. Some super conservative traders suggest that the traders should be even looking for an RRR as high as 1:5. The risk to reward ratio is an essential aspect of trading, and it acts as an integral part of a strong money management strategy. This may seem like an easy task, but it is fascinating how traders forget about it once they spot a strong trading signal. That’s exactly when you need to calculate & follow the Risk to Reward ratio.
If you are not aware of the RRR, there is a possibility of you taking the trades that are not really worth taking. You buying a security at resistance or selling them at support are among the many examples of ignoring your Risk to Reward Ratio. You will come across conflicting signals many times on the charts, but that doesn’t mean you take the trade in both the directions. For instance, if you see a buy signal, but resistance hasn’t been broken yet, and the risk to reward ratio is terrible, there is no point in taking that trade.
In a scenario where your stop-loss is 200 pips, and your profit target is 100 pips, it is better to avoid that trade as the RRR is terrible. The idea is simple. It is about the odds and probabilities. If the odds are against you, never consider that trade at all. To become profitable in trading, the odds must always be in your favour, and the fundamental way to do it is to look for a RRR of at least 1:1 or higher than that. Bigger the RRR, the better it is. But always remember not to narrow the stops way too much or widen the targets excessively just to achieve good RRR. The stop-loss and the profit target should always be placed based on the realistic analysis of the market. Traders generally make this mistake. Amateur traders would have read about RRR somewhere and blindly maintain a RRR of 1:5 while they determine their profit targets and stop-loss levels. This is a blunder. The RRR for any trade should be among the last things to do before initiating the trade. It is the last thing, but in no way unimportant. RRR must fit within the broader context of the trade and overall analysis.
Finally, while a higher RRR is of course better, the fact is that the higher it is, the more difficult it is to achieve it. So, remember to keep the expectations real and the risks appropriate. There is no need to avoid perfect trade just because the RRR is not as high as 1:5. In any case, it is on the safe side to aim at a 1:2 RRR, and 1:1 RRR should definitely be the absolute minimum allowable in almost all the situations.
The Importance of Defining Risk
Irrespective of the technique adopted, the process of pre-defining the maximum permissible risk on a trade is essential. It helps the trader think through a series of essential questions:
- How significant is the risk compared to available capital?
- Does the potential reward justify the risk?
- Of the other trading opportunities available, what proportion of capital should be risked?
These are the questions a trader is supposed to think through before taking any trade with respect to risk. These questions can help a trader in self-analysing the risk he is willing to take, and if it is permissible. By doing this a trader can not only mitigate the risk or have foresight of the risk he/she is going to incur, but it also gives him/her the power to confidently execute the trade.
The Importance of Estimating Reward
Estimating reward, in particular, is very useful in capital allocation decisions. Reward estimation can help pick up the top trades and act upon them accordingly. Traders prioritise the top-yielding trades based on the estimated reward. The higher the estimated reward for a given leverage investment, the higher the potential return on investment is. Likewise, the higher the estimated reward for a permissible dollar risk, the higher the RRR. It is obvious to say that if the reward of a particular trade is more, the risk will be more. They are directly proportional. So, estimating the reward can not only be helpful in making capital allocation decisions but also in estimating the risk and mitigating it.
Planning your Exit
Planning your exit is as important as entering the trade. There are many exit strategies that you can use to book some significant profits. Some traders take profit along the way, and some traders have the patience to wait until the final target. It depends on how you read and understand the market. You have to exit on the way down when the market is not that volatile, and when the market is volatile, and the momentum is looking good, you can plan your exit where you can milk money. It all depends on the condition and state of the market.
There is not much difference between the Entry and Exit strategy. If you are good at entries, then you will automatically be good at exits. Planning is important. You should know when to take your profit early and when to hold on to the trade. It ultimately boils down to the momentum and state/condition of the market. Some of the exit areas are Supply and Demand areas, S & R’s, Recent Low and Recent High.
The best exit will be coming from the higher time frame as the time frame above your trading time frame is moving the market.
As a trader, you are bound to be disciplined. Trading is just like any of the other businesses. If you are not sticking to your rules, you will lose money. However, you will make money in some trades or the other. But as a professional trader, you should make money each and every month, year and decade and that’s precisely what being consistent is. Consistency is the key in any business, and if you abide by your rules, you will be consistent. If not, you will lose for sure. Below are some of the pro tips you need to follow in order to maintain discipline.
- Maintain a Journal – Write down each and every trade with exquisite detail. You also can record a video or audio.
- Keep telling yourself this – If the market is doing this, then I will enter, if the market is not doing this, I will ignore and look for another opportunity.
- Don’t force your trades – Don’t take the trade if the trade opportunity is not in sync with your rules. Wait for the trades that have a higher probability of winning and are in sync with your rules.
- Wait for your turn – You need to be strict with your rules. Don’t break them what so ever.
We hope you understood the critical components of Risk Management. Applying these in your daily activities makes you a holistic trader. If you have more risk management techniques, we would be more than happy to see them in the comments below.