When I started in this business back in 1987, one of the first events I witnessed was a Market crash now infamously known as Black Monday. When this happened, I was a rookie broker and had very little money, no experience and not many clients to speak of. What came from that experience were some valuable lessons.
One of the lessons I learned was how investors and traders with no plan on how to manage risk can suffer outsized losses when the market sells off in a dramatic fashion. Another was that the market can be an unforgiving place for those that don’t know what they’re doing. In other words, I learned how risk plays such an important role in trading in all markets (stocks, futures, Forex and options).
Two Aspects of Risk When Trading
Traders Must Be OK with Losing Money
Traders have to be comfortable with taking risk. In other words, they must be willing to lose money (as long as it’s a small amount relative to their reward potential) in order to realize their desired result. This seems like it should be a given, as most traders realize that not all trades will produce profits, but in my experience this is a major challenge for many because most people are risk-averse. This risk-taking mindset doesn’t come naturally because of the strong human tendency to avoid pain and seek pleasure.
For most traders, losing is painful and thus they spend most of their energy in figuring out how to not lose. Some of the action they take in order to avoid losses are things like moving their stops too early, using trailing stops and taking small profits. Unfortunately, as traders eventually find out after doing this for an extended period of time, those types of maneuvers only serve to produce paltry returns if they’re fortunate enough to survive the inevitable drawdowns that come.
Instead, what if traders learned a skill that allowed them to take low risk, high probability trades. This serves two benefits: traders would be less emotional and they would be more mechanical in their process.
How does one go about that, you ask? First, traders must develop a simple, rules based process that looks to anticipate where the market is likely to turn and how far it will travel in the opposite direction. After all the rules are place, then they must test it through a large (30 trades or more) sample size of trades to confirm that it indeed produces evidence-based desired results. After all the testing is finished, a trader must have the discipline to apply the rules daily.
Managing Trading Risk Properly
Managing risk properly means keeping losses small. When trading in the Futures market this becomes even more critical as Futures carries a high degree of leverage. Traders can keep losses small by only taking trades that risk a small percentage of their account balance.
A good rule of thumb would be to only risk 2% of the accounts total value. That’s to say, if a trader has a $10,000 account, they shouldn’t risk more than $200 on any single trade. This amount should have a potential reward of three times that of the risk taken. In other words, a $600 target should be offered if the risk on the trade is $200. The aim is to give a trader a chance for profits even if the win-to-loss ratio is not great.
Additional Futures Specific Risk Management Consideration
Managing risk in the futures markets could also entail considering closing all positions on Friday, as the risk of a gap opening increases over the weekend. This is because the futures markets are closed and any surprise headline may produce a big order imbalance on the opening on Sunday.
Market speculation is all about risk. You must take on risk to expect returns but you must also be diligent about not taking too much risk as the goal is to fight to live another day, as the saying goes.
I hope this helps you get a better understanding of some of the aspects of risk management and that it spurs you to make changes in your own trading so that proper risk management can help you to achieve your goals.
Until next time, I hope everyone has a great week.