It’s night time and you are tired but still ready for a bit of excitement. You’ve been biding your time the last few days, waiting for the right opportunity, and tonight it’s looking good. The signals are positive, the adrenalin is flowing. You reach out a hand, ready to make your move. Caution be damned, you are going for it.

But WAIT. It’s at times like this, when you are thinking about it least, that you most need protection. And you know what I’m talking about, right? Yep - what you need is some Risk Management.

Hey, if you’ve lost on a few trades recently you’re in good company. Top traders make their money on between 40-60% of trades (so it doesn’t take Stephen Hawking to work out that 40-60% are losing trades). I’ll state the blinding obvious but they get rich by making more on the winners than they lose on the wrong ‘uns.

The thing that separates the guys with the Sunseeker cruisers (that’s a boat, not a friend of George Michael’s) from the rest is that they approach each trade with a trade plan and they look after their money very carefully.

There are three parts to successful trading
1) Having an opinion. That’s the buy or sell decision and if you get that wrong it’s off for an early shower.
2) Trading tactics. This is deciding when to trade. With a choice of buy or sell you’ve got a 50% chance of being right, but if you enter the trade at the wrong time you could suffer the double whammy of being stopped out and then seeing your missed profit mooning at you as the market does just what you predicted.
3) Risk management. Looking after your capital and how much to risk on a bet.

There’s already quiet a few Views & Opinions articles to help with (1) and (2). This post looks at No 3.

Trust me, if you’re a normal guy rather than a genius, trading will improve massively over the first couple of years; the key is to keep your trading capital longer than Britney Spears holds onto her kids. And you do that through risk management.

First off, there should be only two states of mind when trading:
1) Creating the buffer zone. Start with small bets to create a new layer of capital (your profits) before increasing the bet size. Think Hitler, he didn’t jump straight into France; he built his buffer zone of the Saarland, Austria and the Sudentenland first. Gradually increase the bet size as your capital grows but save your shirt for a night out on the town, don’t go losing it on FTSE.

2) Preserving capital. When a few trades go t*ts up (that’s a normal part of trading) and eat into the capital base there might be the temptation to not deal. That’s cool, and even advisable, just to retrench, re-assess your strategy or market view, and stop the rot. But trading’s the game so get back on the bike, but cautiously. Perhaps drop the bet size, pick lower risk strategies until you’ve started to re-build the capital base.

What We Need Is A Good … Trade Plan.
Think about decorating your house. Sorry, I didn’t mean to sound like the missus; it’s just an illustration. If you’re Billy Bodgit you can just paint over the last coat and it’ll save you time and money-for a while. But when the paint starts blistering and untreated damp seeps through you don’t look so clever. Think of your trade plan as the sanding, treating and priming (the hard work that goes unnoticed) before the fancy paintwork goes on.

The trade plan is a discipline, which should prevent the impulse trades and focus the mind on what you hope to get out of the trade. Traders target a risk: reward ratio, which varies according to the size of their dangly bits; a popular ratio is 3:1 (the potential gain is 3 X the potential loss). In that way they make money even if only one in three trades wins.
Before pressing the trade button the plan should show where you’re prepared to enter the trade, where you get out if it goes t*ts up and where you aim to take profits.

OK, so the name of the game is controlling our exposure to risk. The three control dials are:
1) Bet size.
2) Frequency of trading
3) Time frame (duration) of trades.

Numbers (2) and (3) are important, and worthy of discussion over a pint but (1) is bang-on vital.

Sometimes Smaller Is Better
Newbies start by deciding the bet size then working out where to put a stop loss; risk management suggests the opposite.

The cunning plan is to limit the possible loss on each trade to a set percentage of your trading capital. Typically the big swingers might look at risking 5% of their capital on a trade, but you can play with this percentage to suit the size of your capital and risk tolerance. This allows you to get a few wrong without denting your confidence or bank balance.

Ok, it all gets a bit Carol Vorderman here, but it’s worth it so hang in there. Supposing your trading capital is £5000 and you’re willing to trade 5% of your capital. That means you’re prepared to risk £250 on the trade. You want to buy FTSE at 6525 with a stop loss at 6475 (50 points below). That means that you can afford a bet size of £5 (£5X 50 points = £250). A wider stop loss would lead to a smaller bet size; a tighter stop would allow you to risk a bigger bet.

Frequency Of Trading
The theory goes that the more times we’re in and out the greater the risk … and yes, I am still talking about trading here. More trades equals a greater chance of picking a ‘wrong un’. This one’s a lot more debateable and one of our regular traders, Lao Gao recently asked the question,

“To be successful should you either make lots of bets with tight stop losses and wait around for a whopper or should you make fewer bets with very wide stop losses then you generally win, but when you lose, you lose big?”

I find that I prefer the first one, dealing frequently to try and get a feel for the market, but I’m the first to admit that that mind-set often leads to taking profits too early. I suspect that the best strategy is somewhere in between. However when I mentioned that to Z, another blogger on paddypowertrader, he said that he can make one or the other work, but the middle ground is the one that costs him money.

I’m trying to develop my style, separating my trades into two categories:

• The ‘smash & grab’ trades, where I’m in and out like a scrum-half in a ruck, are usually where I think I can catch a few pips from a market move. I trade these in £8 lots with a fairly tight (20-30 pip) stop loss in case I’m wrong, and I don’t hang around once I’ve reached my target.
• Trending trades, which I view as better quality, but where I use a smaller bet (£2-4). I use a wider stop loss to give the trade room to work and I try to keep on board for the bigger move.

Long And Slow Or Quick In Quick Out
Here the argument goes that the longer a bet is exposed to the market, the greater the risk, though of course, the risk could be good or bad. There’s a dangerous tendency to stay in a trade ‘knowing that it will come right in the end’. Hey, there’s nothing wrong with a longer time frame so long as you keep to your plan. Some traders impose a timed stop loss as well as a financial one, saying that if the move hasn’t worked in that period then the reason for the trade has gone. There’s also a small financing angle to be aware of as quarterly bets have wider dealing spreads; daily bets can be rolled over for a small charge.

OK, I’ll hold my hand up; I’m trying to practise what I preach, but I’m not the finished article (the missus thinks I should be sent back with a design fault). If shocking figures suddenly hit the market I don’t spend 10-minutes on a trade plan, I trade. But I do know the discipline will save me money in the long run.

What do you guys think? In and out with a tight stop, or less frequent trades with a wider stop? Tell us what works for you in the comments section below.

A good way to finish an article on risk management is to refer you to Z’s excellent recent article highlighting The Golden Rules of Spread Betting.

And finally, if you can still remember the start of the article, I thought I’d share the following with you. Next time you think of trading without risk management, think of this!

Happy Trading