Effective risk management techniques at trading

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Traders spend much of their time looking at charts and analyzing, using technical or fundamental analysis, or a combination of both. While these indeed are very good things to spend time on, not all traders take the time to focus on, risk management, and more specific, position sizing. – Reza Abbaszadeh

I see a lot of new and old traders or investors who trade, only to have their accounts blown up by taking random positions, with no plan whatsoever. Proper position sizing is a key element in risk management and can determine whether you live to trade another day or not.

Basically, your position size is the number of shares you take on a trade. It can keep you from risking too much on trade and blowing up your account. Without knowing how to size your positions properly, you may end up taking trades that are far too large for your account. In such cases, you become highly vulnerable when the market moves even just a few points against you. Risk management at trading.

Your position size, or trade size, is more important than your entry and exit when trading or investing. You can have the best strategy in the world, but if your trade size is too big or too small you’ll either take too much or too little risk.

how do you prevent yourself from risking too much? How do you know the right quantity to buy or to sell when you initiate a position?

Let’s say you have $10,000 in your account and there’s a stock valued at $100 you like and want to buy. Do you buy 100 shares, 10 shares, or some other number? This is the question you must answer—how to determine your position size. If you decide to spend your entire account balance and buy 100 shares, then you will have a 100% commitment to this stock. And that’s not indicated. Also, in taking a position that represents a large portion of your total portfolio, there is also the opportunity cost involved.

You would have to pass up other trades that you may have liked to enter. Position sizing is a critical issue that a trader needs to know beforehand and not do on the fly. It’s as important as picking the right stock or currency to invest in.

Newer traders or investors like to calculate how much they could make on the upside, how much money they could potentially make, and focus less on how much money they could potentially lose. There are several approaches to position sizing, and I will run down some of the more popular ones.

The first one, and the most common one: Fixed percentage per trade

Position sizing can be based on the size of an overall portfolio. This means a percentage of that overall capital will be predetermined per trade and will not be exceeded. That could be 1% or even 5%. This fixed percentage is an easy way for you to know how much you are buying when you buy. (Risk management at trading.)

To use a simple example of fixed-percentage position sizing, take again a $10,000 account size and a $100 stock. If you take a simple 1% position based on your account size, that comes down to a single share. You may be thinking you are no better off than a person with a $100 account buying one share. The difference is that the $100 account holder has a 100% position size while the $10,000 account holder is putting just 1% at risk. (Risk management at trading.)

Which position size allows a trader to sleep better at night? Of course the second one. Position sizing helps control risk.

A 1% hard limit on each trade allows you to tolerate many losses in search of profits. Protecting your capital is your primary job. Your secondary job is allowing room in your portfolio to find other trading opportunities. The fixed percentage amount is an easy approach to accomplish this. (Risk management at trading.)

The second risk management approach involves a fixed-dollar amount per trade

This approach also uses a fixed amount but this time it’s a fixed-dollar amount per trade rather than a percentage of the actual portfolio. This involves choosing a number.

Again using that same $10,000 portfolio as an example, say you decide you won’t spend any more than, say, $200 on any one trade. For traders with small account sizes, this can be an attractive approach because it limits how much you can lose. However, it also limits what stocks you can buy. (Risk management at trading.)

You will have to rule out some securities based solely on their price. Of course, this is not necessarily a bad thing.

The third approach: Volatility-based position sizing

A more complex approach but one that allows for more flexibility is position sizing based on the volatility of the security you plan to purchase. It’s more dynamic because it doesn’t treat each stock the same. This approach allows you to really drill down and exercise finer control over your portfolio. (Risk management at trading.)

For example, growth stocks will invariably be more volatile and that volatility will be reflected in your portfolio. To reduce the overall risk of your portfolio, you would buy less of higher volatility stocks than you would buy lower volatility stocks. You can measure volatility with something as simple as a standard deviation over a given period, say, 15 or 10 trading days. Then, depending on the deviation, you adjust the number of shares you buy when you initiate a position.

This allows lower-volatility stocks to have more weight in your portfolio than higher-volatility ones. Position sizing based on this ideology lowers overall volatility within a portfolio. This strategy is frequently used in large portfolios and I use it personally in my own portfolio. Even longer-term traders and investors face position sizing questions. (Risk management at trading.)

For them, when the price of security they are holding goes down, it represents more value. Adding to their position, in this case, is referred to as averaging down. Long-term traders can decide to average down using similar position-sizing approaches, by risking either a fixed-dollar amount or a percentage amount when the stock trades down.

You can use standard deviation here as well to help figure out that amount. Averaging down needs to be used with caution because if your analysis is wrong, at some point you’ll be in a position that is no longer worth holding. You don’t want to average down to zero by buying all the way down. Some additional common-sense risk parameters seem worth mentioning and may be incorporated into your trade plan. (Risk management at trading.)

For example, to be safe, you must be able to accept losing on any given trade and to be able to survive taking losses on ten consecutive trades. And those ten consecutive losses should not exceed a total 25 percent drawdown. This means that no more than two percent of the portfolio should be put at risk on any particular trade. (Risk management at trading.)

Once you figured out how much you are comfortable losing, a stop loss level for each trade should be determined and placed in the market.

A seasoned trader will generally know where to put their stop-loss orders after having optimized their trading plan, and chart analysis is often performed when setting stop-loss levels. (Risk management at trading.)

Two rules of thumb should be followed when you use stops to manage risk in your positions:

1. Never adjust the stop loss to arrive at the desired position size, but instead, adjust the size of the position to meet your risk level and desired stop-loss order placement based on your analysis.
2. Trade using the same risk parameters on every trade regardless of the distance of the stop loss.

Avoid putting more money at risk to use a wider stop, and avoid risking any less money on a stop closer to the trading level. Adjust your position to meet your predetermined risk levels. (Risk management at trading.)

By now, I hope you realized that correct position sizing is crucial. You should always consider how much you buy when you buy, and also, know how you came up with that number. Regardless of your account size, take the time to come up with a consistent approach that matches your trading style and then stick to it. You can incorporate flexibility. For example, if you are willing to take more risk with your portfolio, you can dial up the percentage you use. (Risk management at trading.)

Sound risk management techniques can help make an average trader become better, and a good trader becomes great.

For example, a trader that is only right half the time but gets out of losing trades before the loss becomes significant and knows to ride winners to a substantial profit would be way ahead of most others who trade with no clear plan of action whatsoever. And you have to find the right balance because if you risk too little and your account won’t grow, and if risk too much and your account can be destroyed in few bad trades. (Risk management at trading.)

If you found value and learned something new, leave us a like to show your support and make sure you subscribe and hit the bell icon to stay notified when we upload new videos. Until next time. – Reza Abbaszadeh