The topic of today’s article will be on one of the most important topics in trading, yet one of the most overlooked by new traders. This topic is risk management. I can see some of you long time readers rolling your eyes, just bear with me! This old, boring topic is one of the most, if not THE most, important issue in trading. Too many new traders spend a huge portion of their time looking for that perfect setup or set of indicators that will make money on every trade, trying to get rich quick! If you have been trading for more than a few months, I know you’ve spent time searching for that Holy Grail! Most of the new traders that I meet ask what my favorite indicator is, a moving average, Bollinger Bands, Stochastics, etc. etc. My response to their question is “good risk management.” So let’s go through some recommended rules to help with risk management.
One of the first rules we teach is your reward to risk ratio. This is where you are willing to give up or lose a bit of money, looking to make a bit of money. Many traders start with a three to one reward to risk, where if I risk $100 my trade must have the potential to make $300. Pretty easy, right? Actually, that rule is almost too simplistic for real trading.
One interesting thing about this ratio is the difference between what our PLANNED reward to risk was vs. what the REALIZED reward to risk ended up being. When trading, you will find that when trading WITH the trend your realized reward to risk ratios will often be better than your planned ratios; when trading AGAINST the trend, very often your realized reward to risk ratio will be worse than planned.
In this chart of the AUDUSD I inserted a 20 period simple moving average. One of the easiest rules to determine trend is to look at what direction your moving average is pointing. Pointing up, uptrend, look for long trades. Pointing down, downtrend, look for short trades. (Yes, there are more effective rules but we’ll stick with the easy one for this discussion.) Using Online Trading Academy’s core strategy, I will look to go long at pullbacks to demand and go short at rallies into supply. Very often new traders will show me their trading history, and many times I will see that they are trading against the dominant trend direction. They will tell me that they are trying to get a 3:1 or better reward to risk ratio but they keep getting stopped out before their profit target is reached. The more experienced readers will probably recognize this problem as most new traders seem to have this issue at least once in their lives! Here is a possible quick fix to add to your trading plan:
When trading against the trend I will go for a 2:1 reward to risk ratio and take all profits at target one.
When trading with the trend I will go for a 4:1 reward to risk ratio, taking half position off at target one and managing the rest of my position using a manual trailing stop (or whatever your preferred method to trail is.)
Another rule of risk management that I believe should be in your trading plan is limiting the number of trades you take in a specific day or week. There are a couple of ways to do this. For example, some day traders will limit themselves to only 3 trades per day. This rule helps them be more selective in their trades. If you are planning on looking at your charts for 5 hours today, and you only have 3 trades to take, you will probably be pretty selective on which trades you take! My preferred rule for limiting trading activity is to use a daily (or weekly) loss limit. A common daily limit range is 3-5% of your trading account. Using a LOSS limit instead of a trading limit allows the active trader to continue trading as long as he or she is profitable! Why limit yourself to 3 trades if you are having a great trading day? Why not trade 5 times, or even 25 times if you are making money and want to be that active? Having the percent loss limit might mean that after your first 2 trades you may be done for the day. Oh well, come back tomorrow and trade again. Without a loss limit, some new traders have slowly lost their entire account as they tried to keep trading, just to “get their money back.”
Written by Rick Wright, Online Trading Academy Instructor
Rick Wright’s goal as an Online Trading Academy Instructor is to accelerate the student’s learning curve, whether they are interested in High Frequency Trading or Investing for Beginners. He teaches classes on Online Stock Trading, Forex Trading and Futures, among others.
Rick studied economics and psychology at Iowa State University, and entered into the brokerage business in 1992. He earned the NASD Series 4,7,9,10,24,55,63, and 65 licenses. He helped grow an online brokerage business which was eventually sold off. Rick has also held positions as broker, branch manager, and several VP positions in the brokerage business.
Rick began trading equities in 1997, and was introduced to the Forex market in 2002. Currently trading from home in Dallas, Rick is also a frequent contributor to various TV and business talk radio shows.