LEVEL: INTERMEDIATE
Trading the financial markets requires a sound strategy that employs robust research, a technique for initiating a trade and solid risk management. Managing risk appropriately is the key underlying element for successful returns over the long term. Risk management as it pertains to individual trades focuses on the exit point of a trade which is often overlooked when a trade is initiated. The focus of this article will be to examine how to think about risk and some of the techniques that can be used to generate robust returns.
The Plan
Money management focuses on the amount of capital that will be at risk on a specific trade. This concept can be broken down into the expected gain or loss as it relates to the expected and actual return on a trade, along with the potential bet size for each trade.
Prior to initiating a trade, an investor should formulate a strategy that defines the profit and loss that they are willing to accept. An investor also needs to determine a prudent risk-reward profile in which the profit is a multiple of the loss. Although there are a number of trading strategies that win more than they lose, there are very few that will be successful over time if the amount of loss on a trade is a higher multiple of the profit made on a winning trade than vice versa. In other words, if you are willing to lose more than you are looking to win, your strategy will probably not be successful.
An example of how risk management directly affects a trading strategy is as follows. If an investor is planning on making twice as much on a winning trade than losing on an unsuccessful trade, he would need to win slightly more than 33% of the time to have a successful trading strategy. Exactly 33% would break even. The math reflecting this scenario would work as follows:
Let’s assume 9 trades. If there are 3 winning trades at $4 dollars per share (for a total of $12 dollars in profit) and 6 losing trades at $2 per share (for a total of $12 dollars) the strategy would be break even.
From this example, the risk profile shows that the winners and the loser would cancel each other out, generating zero profit. Slightly more than 33.3% would allow an investor to generate gains. A different risk reward profile would require either a greater percent of gains on the strategy or a more robust risk-reward profile to generate a successful strategy.
When entering into a trade, the trader most have a specific idea of where they would want to stop out of the trade, and where they would want to take profits on a trade.
Creating a Stop Loss
Prior to initiating a trade, an investor should first determine the amount of loss he or she is willing to accept, based on a market movement against the position.
The stop loss determines how much capital a trader is willing to risk on a trade. Stop losses can be based purely on a notional amount of money, such as risking $100 dollars, or a percent move in the market. Using the risk capital, investors can back into a specific price which equates to a stop level.
There are a number of techniques that can be used to help determine a robust stop loss. One of the most popular ways to pinpoint a stop loss level is to use support and resistance price levels, which when breached trigger a stop loss.
Source – www.stockcharts.com
As an example of stop loss levels, an investor who is long the SPY ETF could use an upward sloping trend line using the lows created in June with the lows from July which creates an intercept near 136. A stop loss for a short position could be the horizontal trend line which uses the highs made in early April. Additionally, a moving average such as the 50-day moving average near 135 could act as a level that could be used for support for a stop loss.
A trader could also employ a trailing stop loss that is dynamic and moves as the market moves. Trailing stop losses can be a point on a chart, for example the low of the prior day during an uptrend, or a percent calculation, such as 1% below the last close.
There are many ways to optimize a trailing stop to maximize trades. Historical price movements on specific financial instruments can be back tested to determine the best way to maximize gains relative to trialing stops.
Taking Profit
Deciding how much profit you are hoping to take on a position prior to initiating a trade is just as important as determining how much should be risked on a trade. The take profit level is combined with a stop loss level to determine the risk-reward profile an investor will use on a specific trade.
Investors should use market levels to create a risk-reward ratio that is above 1 prior to initiating a position. A risk reward ratio divides the profit by the loss to create a ratio. For example, if an investor planned on making $2 on a trade and was willing to risk $1, the risk reward ratio would be 2. Support and resistance levels are robust ways to use to identify a take profit level.
Risk/Reward
The essence of a trailing stop loss is that each time the market moves higher, the risk reward profile of the trade remains similar to the initial risk reward profit. This is called maintaining the risk/reward profile. A trader should avoid placing a trailing stop loss at levels where they are risking more once they move their stop loss, than they were initially risking.
Conclusion
Risk management is an extremely important function of successful trading. Many times the concept is lost as investors focus on a theory behind purchasing a stock and its long term relative value. The underlying focus of a potential trade should be the amount that will be risked compared to the potential reward which is the risk reward ratio. Focusing on risk management will allow investors to remain solvent and generate robust trading strategies.