Risk management. It’s not something talked about very often, especially in a fast-paced and profit-focused profession such as trading. But for me, it is one of the more important things that I like to always emphasise to any trader.
I know. It’s not a sexy topic. There’s no dollar signs to it. It’s simply just not flashy. But what it is though, is something that could make or break your trading at the end of the day.
One of the biggest misconceptions in trading is that success often comes from learning how to predict markets better. Of course, having a good read on price action helps. However, I would argue that learning how to manage what happens when you are wrong is just as important, if not more so.
And that is really what risk management is about.
Think of trading like playing through a full season of football. You are not trying to win the championship with one spectacular pass in the opening match. What you should be striving for is to try and put yourself in a position where, over dozens of matches, you have more opportunities to win than lose.
And that also means needing to make sure that one bad match does not end your entire season.
When it comes to trading, you can have the best analysis and setup in the world and still be wrong on that particular individual trade. Markets are never a given. Unexpected headlines can pop up. Technical levels can break. What might look like a good trade five minutes ago can suddenly fall apart just as quickly.
Now, risk management does not stop those things from happening. But what it does at least, is it maximise your chances of succeeding despite them.
Before entering a trade, if I know where my idea becomes invalid, how much money I am willing to lose and where I would take profit, I have already removed a great deal of uncertainty from the decision.
And that matters a lot from a psychological perspective.
Without those boundaries, every little price move suddenly becomes emotional. A small losing position can easily put you in the line of thinking “maybe I should give it a little more room”. You then move your stop and the trade gets averaged down. Before long, what started as a small, manageable loss becomes something much bigger.
And that is how traders get themselves into trouble without any proper risk management and discipline.
Know where the game ends before you start playing
Technical tools are your best friends when it comes to risk management.
A stop-loss is perhaps the most obvious example. However, the important part here is not simply placing a stop somewhere because you have been told that every trade needs one.
Ideally, the stop should tell you where your trading idea no longer makes sense.
As an example: If I am buying because price is holding above a major support level, then a sustained break below that support might be the point where my thesis is wrong. That gives me a logical place to define and limit my risk.
Support and resistance levels, recent swing highs and lows, moving averages and volatility measures such as the Average True Range (ATR) can all help traders identify where that boundary might sit.
The key here is that the technical level defines the risk first. Then, your position size needs to fit around it.
If my stop needs to be further away because volatility is higher, that does not mean I simply accept a bigger potential loss. I can choose to reduce the size of the position instead. That way, the technical setup determines where I am wrong, while position sizing determines how much being wrong actually costs me.
Your first job is to stay in the game
There is a reason professional athletes talk so much about the need to be consistent.
A tennis player does not try to hit a winner on every single shot. Sometimes the smartest decision is simply to keep the ball in play, wait for a better opportunity and avoid making an unforced error.
And trading is quite similar in that regard.
You do not need every trade to be a winner. What you need is enough capital left to take advantage of the next good setup and trade opportunity that presents itself.
If you risk 50% of your account on one trade and lose, you now need a 100% return just to get back to where you started. But if you lose 20% on a couple of bad trades instead, the climb back is much more manageable.
The mathematics alone explains why staying in the game matters so much.
Think of it this way. A few bad trades should at most, hurt a little. They should not be enough to wipe you out completely.
Bad trades will always happen. That is just part of trading. So, the aim here is not to eliminate losses. It is to stop normal losses from becoming catastrophic ones.
Trading on “feel” is where discipline disappears
One of the easiest traps that most traders fall into is opening a chart, seeing price moving quickly and feeling like you need to get involved.
There is no defined entry. No stop-loss. No clear target. And no idea of how much capital is at risk. Just a gut feeling.
That might work occasionally, which is arguably what makes that thinking even more dangerous. Getting rewarded for a bad process can convince you that the process was good.
Just imagine a basketball player taking a shot from their own half of the court and it went in the basket. It may have worked out once but in constantly trying to repeat that, they risk losing possession of the ball on a missed shot and eventually get punished by taking on such a risk.
It is the same in trading.
A trade should ideally answer a few basic questions before you click the button:
- Why am I entering the trade?
- What if I’m wrong?
- Where am I wrong?
- How much am I risking if I’m wrong?
- What am I hoping to make if I’m right?
Those questions might seem simple enough to comprehend. But just by going through them, they change trading behaviour significantly.
One crucial aspect is that they slow down impulsive decisions. They force you to think in probabilities instead of certainties. And perhaps more importantly, they make losing trades easier to accept because the loss was part of the plan from the beginning.
That is ultimately why I see risk management as much more than just a defensive trading tool.
It is what gives you the ability and more essentially the room to keep making good decisions. You cannot control whether the next trade will be a winning one or a losing one. But what you can control is how much damage a losing trade is allowed to do.
And if trading is a long game, being able to stay in it no matter the losses may be the most important edge of all.
This article was written by Justin Low at investinglive.com.