Risk Management: The Un-Fun, Must-Know Part of Trading

You can read thick books on risk management, write algorithms as long as your arm, and test strategies till you turn blue. But none of that guarantees you earn money or guarantees against losses. After all, look at how much the big financial institutions lost during the Great Recession.

Managing the risk of your positions doesn’t have to be tedious. Most of it is common sense—with the goal being to make sure that one trade, or a series of trades in a month, quarter, or year, doesn’t have the potential to create a loss so great that you can’t continue to trade. Consider it the financial equivalent of getting hit by a tricycle, not a bus, should you cross the street.

Risk Is Relative—Sort Of

So, what constitutes getting hit by a bus? That’s different things for different traders. For example, with $10,000 in your trading account, how would you feel if you lost $8,000 in a month? Would it prevent you from continuing to trade? It could, especially if that $8,000 can only be replaced by making winning trades with the remaining $2,000. But if that $8,000 represents a small percentage of your resources, then the loss may not be a big deal.

Let’s look at the coin-flip game. You can guess heads or tails, and if you’re right, you win $1. If you’re wrong, you win nothing. You’re more interested in how much you’re likely to walk away with after tossing the coin several times. In this case, you could take $0.50 (the expected value of that coin-flip game) and walk away. Most of you would probably choose to flip the coin. Why? Whether you make $1, $0.50, or nothing would hardly make a material difference to most people. But if the amount you win or lose is higher, then you’ll have to decide how much of a loss is too great to bear. That can be tough for some people, but it’ll make the rest of your risk-management decisions easier.

Defined Risk (Made Simpler)

As a general rule, traders should decide how much they’re willing to risk. For example, say you decide you don’t want to risk more than 20% of your trading capital. That leaves you with 80% of your base to continue trading to attempt to make up any losses. But how much should you risk on each trade? That’s another point to think about. Say you decide not to risk more than 5% of your trading capital on any one trade. That means you could do about four trades, each risking 5% of your capital, and have a max overall risk of 20%.

Of course, setting a max loss for your account assumes you can identify the max loss of your trade. For defined-risk trades like verticals, iron condors, butterflies, calendar spreads, and so on, you could visualize the potential max loss. Fire up the thinkorswim® platform, select the Analyze tab, load up the different strategies, and review the potential max loss before you place the trade. One approach to consider would be to take 5% of your trading capital and divide it by the max loss of the position. That would give you a target number of spreads.

Trading Odds? Use ’Em

If you’re trading uncovered positions like stocks, mutual funds, or naked short puts, it’s a little trickier to figure out how much you can risk with any one trade. You might think using stops defines your risk. But once the stop is activated, it becomes a market order seeking execution at the next available price. If the stock or index moves up or down significantly once the stop is activated, you might not exit your position at a price anywhere near your stop. A more conservative approach would be to look at a likely move in the stock or index over a time period like a day or a week.

One way to do that is with the probability cone on thinkorswim. That helps you see what a 68.27% (one standard deviation), 95.45% (two standard deviations), or 99.73% (three standard deviations) range is likely for a stock or index (see figure 1). You may not think a three-standard-deviation move is likely while you’re holding your position, but those “black swan” moves can come out of nowhere. (COVID-19 crash, anyone?)

Your time frame when looking at the potential loss on a trade with undefined risk should match the time you expect to hold the position. If you think you might hold positions for a week or month, you need to account for greater risk. With more time, there’s risk of a bigger price move.

If you factor in the potential loss of the underlying stock or index making a large move against you, keeping the total risk of all your positions under a maximum risk ceiling might help prevent catastrophic losses.

How Much Can You Lose?

When you risk a smaller percentage of your trading capital, you tend not to have big winners or losers relative to your total trading account. One trade may have a max profit or loss, but when combined with other trades that might make or lose a smaller amount, the effect on your account is reduced. That’s bad if you put up nothing but winning trades, but who does that? Sometimes it may be smarter to minimize the effects of losing trades rather than maximizing the winners. Plus, you may want to consider keeping the risk of all positions basically equal. One trade shouldn’t represent dramatically more risk than the others.

If you’re using a set of criteria to identify the trades you want to place, whether they’re based on probabilities, volatility, technical analysis, or fundamental analysis, each trade has about the same potential to make or lose money as the others. If you start to have a “favorite” and decide to risk twice as much money on that trade as the others, that favorite can end up breaking your heart (and trading account) if it turns out to be a loser. In general, you don’t want one position carrying disproportionate risk.

The 20% rule is handy if you tend to put on positions and not pay much attention after that. But if you monitor your positions through the trading day and have the discipline to exit or hedge positions going against you, it might make sense to increase the percentage of trading capital to risk. How much you want to increase depends on if you’ll have the discipline to exit a trade if it goes bad. Instead of looking at the max loss of a position, you might consider the max loss you’re willing to take when you figure in the number of contracts you trade. For example, you may consider selling straddles or strangles ahead of an earnings or news announcement when implied volatilities have been pushed higher. A short straddle has a potentially unlimited loss on the short call side and the potential for significant loss on the short put side. But that occurs if the stock goes very high, or goes to zero, respectively, and both those events are often unlikely, but it’s always a possibility. So, you may look at the volatility, determine a likely price range, and see what your losses could be at certain prices (the Analyze tab is useful here).

If you have enough experience trading these scenarios, and you’re sure you’ll exit trades when you have to, you could do a larger trade than the max-loss method would indicate. Because you’re watching what the stock is doing tick by tick, if that position reaches a loss you’ve determined is too much, under normal market conditions you could attempt to exit the entire position or parts of it.

Risk management is new again. Failure to manage risk is possibly the single most important aspect of trading that retail traders and investors often overlook. It’s not necessarily fun, and it certainly isn’t the first thing that springs to mind when you think about trading. But when you realize why you’re trading—to make money—then you need to make sure you don’t get knocked out of the game before you even learn how to play. Employing risk management techniques, like those detailed here, could work for different market conditions. It’s safer than having no risk strategies at all.