Risk Management System in Trading
Table of Contents
As a trader, your goal should not be to make the most amount of money in a single trading day, but rather, to cut losses to a minimum. This mentality can help protect a trader’s account. Many people have struggled to implement a proper risk management system in trading and thus end up blowing their entire account! If you can effectively manage your risk, then you have a system that will allow you to succeed in making money by trading.
This is something that is significantly important, yet it is severely overlooked. To be successful and an active trader, one must understand the importance of this single rule. Careerwise, I was able to make 1k-2k a day, which is significant in gains, however, I also managed to lose my entire gains for the week in 3 days. So what is the best method and the best risk management system in trading in order for you to cut your losses faster than ever before?
Trading Risk Management Techniques & Tips
Plan your trade, and trade your plan.
This is such a simple phrase, yet many forget it as soon as the market opens. Just like everything in life you need a game plan to execute anything successfully. This can be the difference between a successful career in trading, or one that ends with a blown account!
The Correct Online Broker
The first priority is to make sure that your broker is the correct one for active day trading. There are many different trading risk management tools and brokers. Some brokers cater to people who make swing trades, and some cater to people who make quick intra-day trading and scalping. You must understand the difference between them and find out which suits you.
Most importantly, don’t take unnecessary risks if you have a chance to practice with a demo account.
Stop Loss and Profit Taking Targets
Without a doubt, this is one of the most important aspects of trading risk management techniques one can have. You must have the ability to execute a plan and when to enter a trade, what your risk will be and when profits will be harvested. A successful trader always knows when they need to buy a stock, at what price and at what price the stock will be sold at. By understanding these key areas, one can visualize the potential movement and evaluate if the risk is worth the reward.
On the other hand, most unsuccessful traders, often enter a trade without having a set game plan or profit points. This is a strategy made for disaster as you are essentially gambling and Las Vegas would be more profitable. If you jump into a trade without the requisite risk management system in trading and therefore unaware of when you will take profits you are risking everything. This can lead to holding a losing stock in the hope that it will return to your entry.
As new traders, I often tell them to not risk more than they are willing to lose. The question most often asked is “what does this mean?” The 1% rule explains this in great detail. The 1% rule states that you should not risk more than 1% of your capital in a single trade. For example, if you have a $14,000 account, you should only be trading with $140. This is a rule of thumb, and as you become more consistent in your trading ability you can increase the dollar figure correspondingly.
Trading risk management tools: Stop Loss and Profit Taking Targets
A Stop Loss is one of trading risk management tools, which are based on price. Once it is reached, a trader will sell the stock or take a loss on the position. It is important to have a predefined stop loss because it gives you the ability to understand and predict when to exit a trade if things are not going in your favor. Once these targets are predefined mentally, it eliminates the mentality of hope that “it will come back up”. This will limit your loss before it escalates
Profit Taking Targets, on the other hand, is the exact opposite. This is a target price at which if reached by the trader will sell the stock for a profit. Why is it important and how do we set it? It is important primarily because it acts as a “greed inhibitor” which is preventative and gives us an indication of how much profit we will make prior to entering a trade. This allows us to become psychologically prepared for the gains and are happy with it. Another question asked is “what areas are good areas to set profit taking targets?” This is primarily based on the technicals located on your chart and your resistance areas. If there is a heavy resistance up top, you can always take 2/3 of your positions off and allow the other 1/3 to continue setting a new stop loss at your resistance line.
Risk Management System in Trading is Based on Risk vs Reward
This is something that is discussed by my viewers extensively. Many first-time traders will not fully comprehend how to set their risk vs reward. A very simple way to fold this in with your stop loss and profit-taking target is as follows: for every 1 risk, you want a min of 2 rewards (1:2). In most cases, I tell everyone to have a 1:3 risk-reward. So for example, if you are buying 1000 shares of an underlying stock at the support of $3 and you are setting your stop loss at $2.80, you are risking $0.20 or $200. Therefore, your reward, in this case, should be $0.40/$400 (1:2) or $0.60/$600 (1:3). Using the numbers above, even if correct 50% of the time and you take 10 trades in a 5 day period you will have 5 losses (($200 x 5 = $1,000) and 5 wins ($600 x 5 = $3,000) meaning your net profit will be approximately $2000.
As a trader, you must know when to enter a trade, what you are going to do if the stock does not go according to plan, and what you will do when the stock does go according to your plan. By having a properly designed and flawless risk management system in trading, you are minimizing your losses and taking profits when needed! Plan to win and win you shall!
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