Lessons from the Pros


Risk Management Strategies, Part 1

Hello traders! This week’s newsletter comes to you from beautiful Washington D.C., a few short days before Online Trading Academy’s annual conference in Southern California. By the time you read this, the entire OTA family will be meeting or have had just met to discuss the upcoming year for OTA. Exciting things are always announced, so I am looking forward to the big meeting! Enough about that, let’s talk about trading!

Free Trading WorkshopSo the topic of this week’s newsletter will focus 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.

Learn risk management strategies to protect capital and increase trading profits

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.”

In future newsletters I’ll add some more risk management rules that some very successful traders I know use in addition to the rules covered today. Until next time,

Rick Wright



DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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