module 4 workbook - amazon s34+workbook.pdf · and control their losses. ... most traders lack...

Module 4 – Risk Management

© 2014 StrongForce, Inc 1

OBJECTIVES In this module you will: ü Define Exactly What “Risk Management” Means in

Trading

ü Understand the Mathematical and Psychological

Impacts of Risk Management

ü Learn a Specific Method to Structure Your Trades So

That You Keep Losses Small and Grow Your Account

Exponentially



RISK MANAGEMENT If you’ve been trading for any amount of time, you’ve undoubtedly heard of “risk management.” If you ask any respectable trader what the most important thing to making money in trading is, risk management will be in the top two. But often those words get thrown around as if everyone already knows what they mean. The reality is that most traders don’t truly understand what they mean and don’t apply the concept to their trading. Which is why so many traders lose money. Now, every trader will lose money. Even elite traders lose money. The difference is that amateur traders believe they can predict the market and will someday find a strategy that wins all the time, so they don’t use proper risk management strategies and they lose money, sometimes all of it. Elite traders understand that losses are part of trading and implement rock solid risk management strategies to minimize and control their losses. If you’re going to become an elite trader, you must be comfortable with losses, because you will have them, lots of them. So what is “Risk Management?” Let’s start with risk. In trading, “Risk” is simply the amount of money you could lose. It’s generally measured as a percentage of your overall account balance. You have risk on individual trades, and you have risk on your overall portfolio. Individual trade risk is simply the amount of money you could lose if an individual trade is a loser. Overall Portfolio risk is the amount of money you could lose if all your individual trades were losers. “Management” is just the process of controlling things. So, “Risk Management” is the process of controlling the amount of money you could lose. Wouldn’t all traders want to do that? You’d think so, but as you learned in Module 3, most traders lack self-discipline. When a trader is taunted with the prospect of making huge money in just a few trades, they crack under pressure and risk management goes out the window. Greed takes over. They are focused more on “capital appreciation” than “capital preservation.”



Capital Preservation vs. Capital Appreciation Amateur traders and even many professional traders fall prey to greed. They want to make a killing and they want to do it as quickly as possible. They’re entire focus is on capital appreciation. However, to be a profitable trader over the long haul, and to make a killing in the long run, you must understand and truly believe that capital preservation is far more important than capital appreciation. Think of capital preservation as “staying in the race.” If you don’t let your foot off the gas pedal, you’ll crash into the wall and have no chance of winning. If you’re lucky, you might make it through a couple of turns, but eventually, you will wreck. If you want to win, you have to learn to manage your speed and stay in the race. The same goes for trading. If you want to make money, you have to learn how to manage your risk and live to trade another day.

Two Sides of Risk Management There are two sides to determining the proper amount of risk for your trades. On one side you have pure mathematics and on the other you have psychology. Mathematically speaking, most simply put, the probability of losing all your money increases as you increase the amount of risk you carry on each trade. Psychologically speaking, the probability of losing all your money increases the further you go beyond your personal risk tolerance. Starting with the mathematics, consider this. You have $100, you flip a coin 1000 times, and you’re going to risk $10 on each flip. How much money will you have at the end of 1000 flips? The answer is, you won’t really know until you’ve actually flipped the coin 1000 times. But, what is for sure is that you have a 93% chance of ending up with $0. Broke. Busted. Out of the game. You lose. Take that same scenario, but now only risk $1 per flip. You now only have a 3% chance of ending up with $0. Much



better odds. In trading, you always want to be thinking in probabilities, and always be acting in ways that puts the probabilities in your favor. You’re probably thinking, “ok, if I only risk $1 I might not go broke but I’m not really going to make any money either.” That is absolutely not true. In this module you’ll learn to keep losses small and later you’ll learn how to let winners run. But the point you need to take away here is that trading is asymmetrical against you. Here’s what that means: If you double your money, you still have the chance of getting wiped out. But… If you get wiped out, you have no chance of doubling your money. So mathematically speaking, you want to find a risk limit that puts the odds of staying in the game in your favor. Getting wiped out should never be an acceptable result. The other side of risk management is the psychological side. Let’s say you choose a risk limit of 2% per trade. Meaning that you could lose 2% of your account balance on any individual trade. On the surface, that may not seem too bad. But in reality, you may not have a trading personality that can tolerate those losses. If you’re trading outside of your risk tolerance, you will not be trading for very long. You’ll mentally take yourself out of the game and when that happens, traders often never trade again. So, even if the risk limit works out mathematically, you must be sure that it is within your personal risk tolerance.

Finding Your Threshold of Pain Think of your personal risk tolerance as your threshold of pain. In other words, how much money could you lose before you tap out. This is going to be measured in dollars, not percentages. Your brain reacts emotionally to dollars, not percentages. For individual trades, you want your risk limit to be such that the amount of money you lose on a single trade does not have any emotional effect on you. It doesn’t get you angry, you don’t lay in bed thinking about it, it doesn’t make you change your plan, and you don’t complain about it. You



just take it in stride and shrug it off. No big deal. Ask yourself what that amount is for you. It will be completely unique to you and your trading personality. It may be $10, or $100 or $1000, or $10,000. Only you can figure it out. It’s often dependent on your account size but; even two different people with the same account balance will have different amounts that they are comfortable losing. The good news is that the risk management strategy that you’ll learn next works mathematically and is almost guaranteed to be within any trader’s risk tolerance.

FIXED FRACTIONAL METHOD It’s finally time to start getting into the actual mechanics of trading. A rock solid risk management strategy is the foundation of all good trading plans. The fixed fractional method will provide you with a good foundation for your trading plan. The single most beautiful thing about the fixed fractional method of risk management is that it is mathematically impossible to get to zero. You can’t get wiped out if you follow the rules. The second most beautiful thing is that it is very simple and easy to implement on a consistent basis. In fact, it’s so simple that once you get it set up in your trade log, you will never even think about it. It will just happen automatically as part of your trading activity. Here’s how it works. The maximum risk on each individual trade is between ½ and 2% of your total account balance. You choose the percentage that is most comfortable for you based on your trading personality and psychology. Note that as you increase the percentage of risk per trade, you will have larger drawdowns in your account, which can be psychologically difficult to tolerate. Generally, if you’re a new trader, it’s smart to start around ½ % and then increase it as you gain confidence and trading proficiency. The important thing is that you are consistently applying the percentage to all your trades. It doesn’t change based on your



account size, it doesn’t change based on how you feel about a trade, it doesn’t change for any reason. As a result, you’re trades will get larger and larger as you make money, but they will get smaller and smaller if you start losing money. An account that uses fixed fractional would have a growth curve that looks like this:

The fixed fractional method can also skew the standard Bell Curve distribution in your favor in terms of the size of your wins and losses. By properly applying the fixed fractional method along with sound profit taking rules, the potential gain for any given trade will always be greater than the potential loss. The skewed Bell Curve looks like this:



The use of the fixed fractional method allows for a compounding effect when you have winning trades. Increasing the size of positions during a winning streak allows for Geometric Capital Growth of your account, also known as profit compounding; decreasing the size of positions during a losing streak minimizes the damage to your equity. Geometric Capital Growth is also called exponential growth. Arithmetic Growth, also known as linear growth, contrasts this growth strategy. Here is a chart comparing geometric growth with arithmetic growth:

Without using a geometric growth strategy, the growth of small accounts would be extremely difficult. In addition, traders who are looking to withdraw income from their trading accounts must implement a geometric growth strategy. Only Geometric



Capital Growth allows for regular profit withdrawals (as a certain percent of equity) without seriously affecting the trading system’s money-making ability. An important psychological point to note is that by risking lower percentages of your equity, as the fixed fractional does, a winning or losing streak does not have a spectacular impact on your growth curve, especially with smaller account balances. Instead, you will experience smoother capital appreciation and much less stress as a trader or investor. And as you learned in a previous module, being a successful trader has more to do with your psychology than your technical skills as a trader. Always be looking for ways to minimize stress and put yourself in a winning psychological position. When the fixed fractional method is combined with stop losses which are based on technical support and resistance levels, you can determine the proper position size to take on each and every trade. (Note: You’ll learn how to choose stop losses based on technical support and resistance levels in the Technical Analysis modules) Right now you’ll just learn to master calculating the proper position size to keep you within your chosen risk limit. So the goal for each trade is to stay within your chosen risk limit (the amount of money you’re willing to lose) and to base your stop loss on technical support or resistance, not some arbitrary price level that has no real significance to the market. In order to accomplish that you’ll need to know the following:

ü Account Balance ü Max Risk (1/2 to 2%) ü Entry Price ü Stop Loss Price

From these four values, you’ll calculate the position size for each trade. The equation looks like this: _________________________________________________ Position Size = Risk Limit / Probable Risk _________________________________________________ where, Risk Limit = Account Balance x Max Risk and, Probable Risk = Entry Price – Stop Loss Price



So, putting these all together gives you the following equation: *Note – This is based on a long position. For short positions, you will reverse the Entry Price and Stop Loss Price. _________________________________________________ Position Size = ( Account Balance x Max Risk )

(Entry Price – Stop Loss Price) _________________________________________________ Let’s run through some examples. Let’s say you have a $10,000 account balance. Using a risk limit of 1%, what would be the proper position size to take when buying stock at $20 per share and choosing a stop loss of $18? Ex 1. Account Balance = $10,000 Max Risk = 1% = .01 Entry Price = $20

Stop Loss Price = $18

Position Size = ( Account Balance x Max Risk ) (Entry Price – Stop Loss Price)

Position Size = ( $10,000 x .01 ) = $100 ( $20 - $18 ) $2 Position Size = 50 shares So what this means is that you could buy 50 shares of stock and only have the risk of losing $100 if the trade went completely against you. But what if you weren’t comfortable with the $18 stop loss level? What if you wanted to use a support level that was a little lower at $16. Let’s take a look: Ex 2. Account Balance = $10,000 Max Risk = 1% = .01 Entry Price = $20

Stop Loss Price = $16 Position Size = ( Account Balance x Max Risk )

(Entry Price – Stop Loss Price) Position Size = ( $10,000 x .01 ) = $100 ( $20 - $16 ) $4



Position Size = 25 shares In this case, since you are risking more per share, the position size is reduced to keep you within the 1% max risk limit.

Size Matters Sometimes, when you have a small account balance or the price of the stock you want to buy is high, you may not have enough capital to make the trade while staying within your risk management rules. This is NEVER a reason to break your rules and go outside of your risk limits. If you face this situation you must either deposit more money into your trading account or trade instruments that are lower in price. For example, you could trade lower priced stocks, or micro-contracts in the FX markets, or options contracts. But NEVER break your risk management rules. One of the biggest mistakes that traders with small account balances make is convincing themselves that it’s ok to lose $100 if they only have $100 in their accounts. You will never become an elite trader with that mentality. You must be thinking in percentages, not dollars. You should trade with the same discipline whether you have a $100 account or a $1,000,000 account. They both have different psychological challenges, but you must always be following your rules exactly the same. Trading with $100 can be difficult from a psychological standpoint. The reason for this is because you’re putting yourself into a losing position mentally. When you lose money with such a small account balance, the fear of being wiped out really wears on you. And on the flip side, if you have a 20% gain on a trade, you’ll only be up twenty bucks, nothing to really get too excited about. If you’re in this situation, it’s recommended that you find a way to increase the size of your account. Whether you start putting money into it from your paycheck or other means, increasing the size of your account will put you in a better psychological position, which will greatly increase your chances of success.

Risk Management with Multiple Trades The example above was based on a single trade but you’ll most likely have multiple trades open at any given time. In



order to stay true to the fixed fractional method of risk management, you must account for the overall risk that accumulates in your portfolio as you open additional trades. It’s very simple to do with a trade log that is set up properly. We’ll get your trade log set up properly in another module, but for now, you’ll learn to make the necessary adjustment manually. To account for the accumulated risk in your portfolio, you simply have to deduct that risk from your current account balance. You’ll want to use the Net Liquidation Value (NLV) of your account to make this calculation. The NLV is the value of your account if you were to close all positions at the current time. It includes all current gains and losses in all positions that you are currently holding. Your accumulated portfolio risk is a value that your broker or online trading platform will most likely not track in a way that is useful for position sizing multiple trades using fixed fractional. You’ll do this on your trade log. Your trade log will keep track of current risk carried in each open trade based on your buy points and current stop loss levels. It will also sum all of that risk up and tell you how much risk you’re carrying in your overall portfolio. Using the NLV from your trading account and the portfolio risk value from your trade log, you can easily apply the fixed fractional method to multiple trades. Here’s what the formula looks like now: _________________________________________________ Position Size = [(NLV – Portfolio Risk) x Max Risk] (Entry Price – Stop Loss Price) _________________________________________________ So in the Examples 1 and 2 above, each of them carried $100 of risk. Using the example below, we’ll set up a third trade to demonstrate how accumulated portfolio risk effects position size. Ex 3. Account Balance = $10,000 Portfolio Risk = $100 + $100 = $200 Max Risk = 1% = .01 Entry Price = $20

Stop Loss Price = $16



Position = [(Account Balance – Portfolio Risk) x Max Risk] Size (Entry Price – Stop Loss Price) Position Size = ( ($10,000 - $200) x .01 ) = $98 ( $20 - $16 ) $4 Position Size = 24.5 shares The position size of the third trade was reduced by half of a share to account for the risk in your portfolio. Now, obviously you can’t buy 24 ½ shares of stock. So what do you do? Round up? Or round down? You will always round down to stay within your risk limit. So in this example you would actually purchase 24 shares. It’s important that you practice and learn to make these calculations manually so that you have a thorough understanding of how your risk management strategy is being implemented. However, in reality, when you have five or ten or twenty positions open at the same time, it’s not practical to be doing this by hand. In fact, it’s not smart at all. You’ll eventually make a human error that may end up costing you money. Your trade log will do this for you. In addition to reducing the possibility of human error, having your trade log make these calculations for you, will reduce the amount of thinking you have to do when entering a trade. It will allow you to focus on important things like executing the rules of your trading plan flawlessly. You want your trading to be as automatic as possible with as little thinking as possible. Especially at the most emotionally charged points which are entering and exiting a trade. The following exercises will help you gain proficiency in implementing the fixed fractional method as part of your overall risk management strategy. EXERCISE_____________________________________________ To apply the information in this module, complete the following assignments.

• Fixed Fractional Worksheet _______________________________________________________

module 4 workbook - amazon s34+workbook.pdf · and control their losses. ... most traders lack...

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