Introduction

Many people enter trading with the hope of striking it big; easy money; never having to work ever again; but reality isn’t like that. As a result, people will deposit large sums of money into these exchanges or brokerages in order to trade stocks, forex, futures, or cryptocurrencies without having any prior knowledge. Some people will even go above and beyond and start with leverage trading without first understanding risk management. What will happen? A trade can profit, go sideways indefinitely, or lose money. After they place their trade, they can only hope for the best, but unfortunately, the trade goes south and the trader starts to see their money being lost. At first it’s a small loss, but then, suddenly, the trader is down 80% of their portfolio, and the worst part is that the “trader” isn’t familiar with what the market is.

Risk management is the most important concept that any aspiring day trader, swing trader, investor, or anything money-related should learn. Many people disregard and think that they understand such a simple concept, but then they liquidate their account and remain outside of the trading game, and then wonder why they lost so much money. Trading requires a lot of discipline and mental fortitude.

Types of Risk Management

When day trading in the live market, there are two types of risk management.

Market Risk and Trader Risk.

Trader Risk is a vague term, but it essentially means what the trader is in complete control of, and the responsibility of a trader is how they plan their trades, their take profit plans, and their exit plans, and how they execute their overall plan.

Market Risk is whatever the market does. Worse case scenarios, what ifs, catastrophic events, and things like that. This can impact certain parts of the market, or potentially the entire market.

The market is uncontrollable. What makes up the market is the actions of everyone and everything. It has too many variables to be controlled, but what can be controlled is the trader’s risk. The trader can take whatever approach they want to the market, but it is up to their choice if they want to take advantage of this.

Risk to Reward Ratio

One of the first things you should learn when thinking about risk management is the risk-to-reward ratio. The risk-to-reward is pretty self-explanatory. Risk is the potential loss, and reward is the potential profit. The most well known of the risk to reward ratios are 1:1, 2:1, and 3:1 risk to reward ratios. Traders determine the risk to reward ratio by taking the distance between the entry and the stop price and then comparing it to the distance between the entry and the take profit target.

Example of risk to reward ratio that is 3:1

The risk-to-reward ratio can also be correlated with the win rate, another concept that will be discussed in the next part of this post.

The Win Rate

There is a common misconception in the trading community that a good win rate is the most important thing to ensure success in trading, but this is not the truth, not even close.

You can have a 90% win rate and still not be profitable, so what is really the most important objective in trading? The answer is money. Having capital to be able to trade with. What good is a 90% win rate if 1 bad trade can wipe out 10 good trades? It is easy to have a high win rate but have a risk to reward ratio of 1:3 or an even higher risk ratio. You can be profitable long term, which is what matters. You can make huge returns really quickly if you risk a lot, but what is stopping you from losing it? While having a good win rate can be important, it is just a small part of the equation.

You are a new day trader, and you place your first trade, and it goes bad. You lose 30%. You were risking too much, and you had a huge position size, 30% of your trading portfolio on 10x leverage. You just sustained a massive loss, so you try to place more trades. You get five profitable trades, but in each you cut the trade early and took pocket money, you left your trade early, you didn’t stick to your so-called “trading plan”, but in the next trade, You just had another loss and your risk potential just ate up the profits that didn’t even cover the initial loss, and now you have just lost nearly 50% of your trading portfolio. What good is that win rate now?

You can have a win rate of 50%, 60%, or even 40% and still be profitable; it just depends on how your risk to reward ratio is set up, and obviously, risk to reward is also a factor that determines the win rate of a trade. With a 30-40% win rate, you only need a 2:1 risk to reward ratio to have a profitable outcome. You may not be able to control your win rate, but you can control your risk to reward, and depending on how many times you win, you can still be profitable if you limit your losses.

HOW SHOULD YOU SET YOUR RISK TO REWARD RATIO

So now you have a basic understanding of the role win rate plays in risk management and also what the risk to reward ratio is. Some traders would use a tighter stop loss and a larger reward ratio, but this would most likely decrease your win rate, especially in extremely volatile markets. The trader could face a lot of losses, but you really only need a 20-30% win rate to be profitable with a 3:1 risk to reward ratio.

Some traders would use a wider stop loss and a smaller target, causing the risk to reward to decrease. This could impact the win rate and possibly make it high, but like I have reiterated in this whole post, a high win rate isn’t always good. The price can supposedly have an easier time reaching the take profit, and maybe you will avoid volatile movements or stop loss hunts, but it all depends on your specific trading system. If you cut profits but sustain massive losses, you probably won’t last long while trading. Another point is that, even if you have a big enough stop loss and think to yourself that there is no way it would hit the stop before first hitting your take profit, then just think to yourself, “What if it starts a trend in the direction of your stop loss or liquidation price? The market does whatever it wants.

The emotions of a trader

A lot must be going through the mind of a trader. Traders must be able to handle stress, understand that they will lose, and have realistic expectations and goals. Some people can risk their life savings in a trade and get lucky, and then never have to work again. It does happen, but most lose their hard-earned money, and others just risk their money again and lose it all again. You can’t just be panicking and cutting off all your profits. You must be confident in your trading strategy or plan. If you are uncertain, then you shouldn’t be playing with your money. You must back test and understand the types of drawdowns. How many times you could lose a trade must be understood. You can lose and you will lose.

There is this phrase that a trading live streamer says that I like, and it’s “Your goal should be to stay in the game, and not get out.” Basically, this means that you need to protect your money because with trading, if you aren’t careful, you can lose your entire portfolio in a heartbeat. An example: 100% position size on high leverage. A simple 2% move can end up being your liquidation and this would be your fault.

If you don’t have your emotions under control, then it can even impact how much time you hold a trade. Some people decide to swing trade, and sometimes holding a trade for a while can require discipline. This can lead to people cutting their profits early and generating massive losses when the trade doesn’t go their way. It’s simple; a larger take profit will lead to more time being in a trade. You must have everything planned out before going to the live market. That is why back testing, paper trading, and understanding market conditions are important. You must know what to expect.

Another reason why many traders never make it

There are many reasons why most traders never make it. Another reason why that is related to the discussion is that they chase a high win rate and a risk-to-reward strategy. Some traders while back testing will spend and waste a lot of time finding a high win rate strategy when a much more attainable and realistic strategy would give them better results with a lower win rate and a proper risk to reward ratio.

A 40-60% win rate alone can give you a profit with proper risk management and it will save you from the stress of trying to be accurate.

So, don’t stress that much about your win rate. Instead, pay attention to how everything impacts the trade; the win rate, of course; risk to reward, and holding time.

Position Sizing

Another important part of risk management is your position size. This part also becomes extremely important once you start talking about leverage trading. Proper position size will ensure longevity in the market, but this can also require discipline. Some people will go all in on a leverage trade, and if they choose cross margin trading, then this means that they probably won’t have money to back up the futures contract if it goes wrong, causing the liquidation where the trader will lose their money. Someone with a reckless position and high leverage can be a victim of small-scale market manipulation, or simple 1-2% moves, so it’s always best to not risk more than you can afford to lose. If you put 5% of your trading portfolio on each trade and you slowly grow over time, eventually you will make more money as your portfolio grows. Your goal in trading should be longevity because if you are reckless, you might just end up like 90% of day traders.