Risk management allows traders to suffer losses while ensuring capital growth. Yet this crucial trading skill is too often overlooked. Do you have it?
In the collective mind, a trader has two main tasks: first of all, the analytical work (fundamental, technical and psychological). It consists in determining the market trend and the probable evolution of prices in order to help him in his investment decisions.
Then comes strategic development, just as critical. It allows to specify the analysis by determining the most promising points of inflection (the entry and exit points).
But there is also one last aspect to be taken into account, although it is generally more neglected than those I have just mentioned. It is risk management: a good trader always analyses the acceptable loss he can cash out per position, as well as the optimal size of each position. In other words, this part is crucial! This is what money management is all about.
Why is risk management so important?
Trading is not an exact science. Even the most experienced trader cannot boast a 100% success rate. However, although the probability of loss is higher than the probability of gain, a good trader has the ability to record positive performances.
How? By applying a good risk management strategy, cutting losses quickly and letting gains run their course.
A trader who does not take this point into account risks going straight to ruin.
What can cause a trader’s ruin?
Several factors can be the cause: stubbornness, early or late exit from a position, lack of rigour,…
Stubbornness: a trader too proud can risk seeing his ego take precedence over his reason. They will continue to follow their analysis, even if they’re wrong.
Early exit: some traders lose confidence after suffering large losses. This can push them out of a position too early, which they had analysed and which could have brought them a lot if they hadn’t left the game hastily.
Late exit: a trader who leaves a position too late (either because they see their gains increase and they still hope to rise, or because their position is losing but they remain convinced that a recovery will take place) is exposed to large losses.
Lack of rigour: a trader who does not push their analysis far enough obviously risks making a mistake by betting on the wrong horse. It is not uncommon for investors to lose huge sums of money after earning a lot of money: they continue to trust their flair that has guided them so far. Unfortunately, without a thorough analysis, it is impossible to sustain long-term profits in trading.
There are many other factors of ruin. However, they must not slow you down in your desire to trade because these risks can be avoided thanks to money management.
How to use money management?
There are two main ways to successfully practice money management.
A trader can take many small frequent stops and try to reap the profits of the few big winning trades. This method generates many minor cases of psychological pain, but it produces some major moments of ecstasy.
The trader can choose to leave on many small gains and take infrequent but important stops in the hope that the many small profits will outweigh the few large losses. This strategy offers many small moments of joy, but at the cost of some very unpleasant psychological blows. With this approach, it is not uncommon to lose a week or even a month of profits in one or two transactions. Obviously, this strategy is more risky and therefore, it’s not the one we advise most.
Some points of attention to reduce the risks
1. Ranking of opportunities
You will first have to analyse the different opportunities that present themselves and rank them according to their risk reward.
The risk reward is the ratio between the results you hope to achieve on a position and the risk that it contains (the maximum loss accepted on that position). The higher the ratio, the better the opportunity.
2. Determination of overall exposure
The overall exposure corresponds to all the risks incurred by a trader on all positions taken. Simply put, it is the total loss that would be borne by the trader if all his positions result in losses.
The higher the percentage of exposure, the higher the risk (and therefore the potential benefits). On the contrary, an exposure of 1% will be less risky (you risk losing “only” 1% of the capital invested) but will not generate much profit.
How to define the global exposure that corresponds to you? It essentially depends on you and…
… your attitude towards risk.
… your ability to lose (and therefore, inevitably, your available capital).
3. Specialization vs. Diversification
As a general rule, it is advisable to diversify your portfolio in order to reduce risks. If a position crashes and you have diversified your investments, you will be less affected than if you had bet everything on the same (wrong) horse.
Note that your approach may be different depending on the time horizon you are targeting:
For medium and long-term investments, diversification is often advised.
For short-term investments, it is generally better to position yourself on a few (but well-controlled) stocks than to over-diversify.
4. Maximum tolerated loss
Defining the maximum loss you are willing to accept will help you avoid excessive losses. For example, if you are prepared to lose a maximum of 2% on a position, place a stop loss at -2% of your purchase price. If the price collapses, you will be automatically out of the position before losing too much. If the price rises, you can adapt your stop loss by gradually increasing it.
5. The optimal size of a position
This depends on volatility: taking a large amount of a very volatile position can be very dangerous for your portfolio. Why? If it increases a lot and fast, the fall can be just as extreme.
What to remember?
Trading is not just about making profits. It is also a question of knowing how to take losses, and especially not to let your losses take over your discipline.
Taking reckless risks, investing without imagining the worst case scenario… It can, of course, work. But for how long?
Be smart, careful, rigorous and you may have a chance to go to the Moon! 🚀