Traders know that risk is an inherent part of the game. While the potential rewards of successful trades can be high, the risks are just as significant. Even experienced traders with good track records can encounter major drawdowns if adequate risk management isn’t practiced. Implementing smart risk management strategies is crucial for long term trading success. In this article, we explore some key risk management techniques that can help traders navigate the turbulent markets.
Know Your Risk Tolerance
The first step is understanding your personal appetite for risk – some traders have a higher tolerance and can stomach higher volatility, while others may be suited for more conservative strategies. Being aware of your risk personality can help determine optimal position sizing and loss limits. Traders just starting out tend to underestimate the risks, so beginning with small positions is advisable even if you feel you have a high risk tolerance.
Employ Stop Losses
Stop losses are essential for managing the downside on individual trades. By setting stop loss orders at predetermined levels, traders can limit losses on losing trades before significant damage is done. While stops do not guarantee execution at the precise level in fast moving markets, they are an indispensable tool for risk control. Traders employ strategies like keeping wider stops for volatile stocks or trailing stops to lock in some profits while limiting downside.
Diversify The Portfolio
The old adage – don’t put all your eggs in one basket – applies perfectly to trading. Diversification across asset classes, strategies, and instruments can help mitigate risks from uncorrelated market moves. For example, holding a portfolio of stocks, options, commodities and currencies exposes you to different risk return dynamics. Traders can further diversify by using different position sizing across investments based on volatility and correlation of returns.
Manage Overall Position Sizes
While stops cover risk on individual positions, traders need to manage overall portfolio risk exposure by adjusting gross and net position sizing. During periods of high perceived risk, successful traders recommend dialling down overall positions. This prevents overexposure that could lead to severe losses in the event of an adverse market move. Traders can size positions lower during uncertain times and increase positions when perceived edge improves.
Use Protective Options Strategies
Utilizing stock options allows employing protective hedging strategies to define risk on trades more precisely. Strategies like long puts or collars can offer downside cushion without totally eroding upside profits. Bear call/put spreads too can offer strictly defined maximum profit/loss scenarios. Effective options use can prevent unanticipated portfolio drawdowns resulting from unexpected volatility spikes. Mastering options greeks is essential for being able to fine-tune risks in directional trading.
Employ Prudent Leverage
While leverage allows traders to put on larger positions for bigger profits, it also magnifies losses when trades go the wrong way. Even the most successful hedge fund traders blow up by ramping up leverage recklessly without appreciation of risks. Margin lending from brokers makes taking on extreme leverage easy – traders should exercise discretion and use only as much leverage that allows them to sleep peacefully at night! Using fixed fractional position sizing is one way to keep leverage consistent even as account size grows.
Follow Stop Loss Discipline
Having predefined stop losses is useless unless traders stick to the discipline of not shifting them to “give losses a chance to reverse”. Moving stops repeatedly leads to accumulating greater losses or getting stopped out at the worst possible time when patience finally runs out. Traders should accept stop loss areas as sacrosanct and choose wider limits if they find they are unable to adhere to their original stop loss zones.
Avoid Overtrading
Eager traders entering multiple trades without solid edge and defined risk points contributes massively to portfolio drawdowns. Overtrading excessively to chase profits or recover losses quickly is a recipe for failure. Trading less with solid risk-reward preparation is far more profitable over extended periods. Traders need to exhibit patience in waiting for low risk, high confidence trade setups rather than feel pressured to remain active every single day in the markets.
Track Risk Metrics
Serious traders continuously monitor various risk metrics to gain perspective on portfolio exposure. Standard deviation, drawdowns, sharpe ratio, beta to benchmarks allows assessing portfolio volatility. Detailed stats helps alter position sizing to manage volatility within tolerance levels through market cycles. Always reviewing performance attribution – breaking down returns from main strategies – gives insight into strengths/weaknesses and where risk needs reducing or exploiting further.
Have A Risk Management Plan
Devising a written risk management plan addressing position limits, loss limits, portfolio diversification, leverage and liquidity policies provides a guideline to navigate uncertainties. Periodically reviewing the risk plan prevents complacency during profitable runs while keeping you prepared always for market regime changes. The plan can incorporate checklists codifying actions to take during periods of outsized volatility in the markets.
Use Protective Market Orders
In addition to stop losses on individual trades, traders have the option of using protective market orders for risk control on overall positions. Orders like stop market/limit orders get triggered automatically once preset market level conditions are hit. This allows quick automated liquidation of chunks of positions if crisis type market moves kick in unexpectedly to prevent catastrophic losses. Protective orders are available based on various market metrics like indexes, yields, VIX etc.
The Reality Of Risk
Even with robust risk management procedures, losses and strings of losing trades are an integral part of trading. Risk management cannot prevent you from having losing days or weeks in the markets. What it can do is prevent catastrophic losses that knock you out of the game entirely. Through risk management, traders retain the ability to come back and regain profits after periods of losses. So while good trading requires exploiting edges profitably, good risk management involves retaining the capital needed to trade another day.
By incorporating strong risk management practices, traders learn to negotiate the inevitable ups and downs of the markets while steadily compounding capital to generate wealth. As legendary trader Paul Tudor Jones famously said – “Don’t focus on making money; focus on protecting what you have.” Wise words all traders should live by.