Risk Management: The Only Edge That Actually Matters

As professional traders, we should be constantly defining and managing our risk.  To many of us, there is no substitute for a rock-solid plan build around risk management.  In this article, we’ll discuss some very important concepts related to controlling risk.

To start things off here, I feel the need to mention that there are several different KINDS of risk… capital risk, opportunity risk, and mental risk to name a few.  We will break them all down here and give some examples of how to potentially further define and/or reduce our overall risk.

The most obvious type of risk is capital risk.  Losing money isn’t fun, but it is a vital part of the trading process.  When I was in martial arts early in my adulthood, I knew there were times when I would inevitably get hit while sparring.  We were not necessarily trained to avoid getting hit… we were trained how to take hits in the best way possible.  Blocking, counter-striking, knife defense, and other defensive and evasive techniques were just as important (if not MORE important) than going into an offensive attack.

This holds true with trading.  We need to learn to take the small punches in order to fight the next fight.  Damage control speaks volumes.  We can use techniques like stop losses, position sizing, the appropriate use of supply and demand zones, hedging, scaling in and out, legging in and out, and just simply using “good old common sense”.  We need to be careful we don’t overexpose ourselves to any one position (or group of positions that are directly correlated to one another).  Rome wasn’t build in a day (so I’m told), so our P/L does not need to be had in a single day or trade either.  While it is absolutely true that a single trade COULD make your week, month, or year, so can a single trade destroy your account in a short amount of time.  Diversifying those funds over a larger number of positions could help reduce the potential of one bad AAPL (pun intended) spoiling the whole darn bunch.

For opportunity risk, we could miss out on great trades if much of our capital is tied up elsewhere.  This is part of the reason why we teach student traders to cut losses quickly while they are smaller.  One advantage to this is to help prevent/reduce the “runaway” trades that tend to turn small losses into larger and larger losses due to pride preventing us from accepting the cold hard fact that we were WRONG.  This word just doesn’t seem to roll off the tongue the way other fun words do, and it can be hard to chew and can leave a very nasty taste behind as well.  Many of us in our “real” jobs (or former “real” jobs) NEED to be right.  Making mistakes can have extremely detrimental outcomes, particularly when it comes to safety and accountability.  In the world of trading, being wrong is not a naughty word.  As a matter of fact, it’s absolutely acceptable and actually encouraged if done wisely. 

Then comes mental risk.  If we become fearful of losses, we mentally freeze up and cannot follow our plan when it comes time to take wisely prepared and pre-planned trade opportunities.  You’re going to have an impossible chance of winning the lottery if you don’t actually go out and buy the ticket in the first place.  I don’t intend to compare trading with playing the lottery, but there are some similarities between playing the lottery, gambling, and trading that could be beneficial to know if studied correctly.  Each of these activities require small losses on a consistent basis

If the event a trade becomes profitable, we could employ the offensive strategies of risk management using mechanical or technical trailing stops, position scaling (up or down), position adjustments, or any combination thereof.  If we choose to move our protective stop loss amounts, we’d most definitely prefer to move our stops in the direction of the profitable move to lock in more and more profit as the trade plays out.  Most of the time this would involve what we call a mechanical technical trailing stop, or to physically moving the stop loss so it follows in the same direction of the winning trade using various price action landmarks, indicators, or techniques such as simple or exponential moving averages, visual controlling swings or zones, or any preferred candlestick structure.  There are also automated trailing stops that stay a certain fixed dollar amount, tick amount, or percentage behind current price.  These are taught in Trading Academy’s Core Strategy course.

At the end of the day, risk management isn’t some optional add-on to trading, it is the strategy. Every trade you take, every position you size, every stop you move or don’t move is a reflection of how well you understand and control risk. The traders who last in this business aren’t the ones chasing the biggest wins, they’re the ones who consistently protect their downside while letting the upside take care of itself.

You’re going to take losses. That’s not a maybe, it’s a guarantee. The question is whether those losses are small, calculated, and part of a larger plan… or whether they spiral into something that takes you out of the game entirely. Manage that correctly, and you give yourself the chance to play tomorrow. Ignore it, and the market will make that decision for you.

Because in trading, survival isn’t the goal, it’s the requirement.