The Four Pillars of Risk Management

Posted by:DKovach in Stocks

Introduction

If you’ve heard of risk management, it may be in the context of some stuffy academic formulas that have little application to your everyday trading.  On the other hand, many presentations of practical risk management for day traders are lacking in some very important ways.

Much of practical risk management focuses on risk to reward ratios.  That is, what is the amount I am willing to risk, in order to achieve a certain profit in a trade?  Ultimately, this question will lead you to formulating profit targets and stop losses.  While these are certainly important aspects of risk management, they are only two of what I call the four pillars of risk management.

Profit Targets and Stop Losses

As mentioned above these Profit Targets (PTs) and Stop Losses (SLs) comprise half of what this article has to say about risk management, so they deserve some attention.  First, we have to set some guiding principles.  Using these, we can determine if a trade is even worth our time in the first place.

We discussed in the introduction about risk to reward.  As a general rule in trading, for every tick, pip, or dollar that you stand to lose, or risk, in a trade, you should aim to make three or more if you’re profitable.  If you are true to this rule, you can actually be wrong in 66% or more of your trades and still break even.

Before getting too excited and entering random trades with PTs and SLs set as discussed above, unfortunately it is not that simple.  One must be very careful to account for the volatility of the product.  For example, if I am trading a stock that is known to swing $1 in a given trading day, it does not make much sense to set a $0.10 stop loss, unless I’m quite convinced I got a really good price.  Otherwise, I’m likely to get stopped out not necessarily because I’m wrong, but because volatility dealt me an unlucky hand.  Accounting for volatility in your PTs and SLs is one way to overcome this, but we could also factor it into the entry price.

Entry Price 

As discussed above, PTs and SLs form a fundamental aspect of risk management and can keep us out of unprofitable trades.  We must account for the volatility of our product when we set these, among other factors.  But also, we could use the volatility to help us get an even better price, rather than just holding the trade under water.  After all, why would we hold a trade under water if we didn’t have to?  This could potentially allow us to make our stop losses even tighter to insure a better risk/reward ratio.

The consequence is that we won’t enter all trades we want to take.  It takes a lot of discipline to not enter a trade, and wait for a good price, especially in the heat of the moment.  But this is a skill that must be cultivated.  After all, as Warren Buffett says, “The stock market is a device for transferring money from the impatient to the patient”.

Trade Management

Nothing is more frustrating to see a winning trade come within inches of your profit target, only for the markets to turn against you, bringing you back down to break even.  Worse still is to watch a winning trade turn completely and hit your stop loss.

The way to get around this is to manage the trade as it progresses.  Why wait for it to trigger a stop loss if you know the trade isn’t going your way?  You may want to bail on a trade if:

  1. Momentum has turned against you
  2. An important data release is about to come out
  3. The trade has stagnated
  4. You see a sudden imbalance in the order book against you
  5. The technicals or fundamentals turn against you

This process will not only help you to minimize losses but to secure profits as well.  It is always a good idea to move your stop losses when you’re onside.  This way, the worst-case scenario is you exited with a profit, just not the profit that you wanted.   On the other hand, the best-case scenario is that you are able to move your profit target up or remove it entirely, simply following your trade as it moves into the green by moving up the stop loss.

Conclusion

The subject of risk management can be daunting and foreboding.  While it does require discipline, consistency, and patience, this post presented some great ideas to get you started.  While risk/reward ratios are a great way to filter out unprofitable trade ideas and to try to lock in profit on positions, one should always strive to get the best entry point possible and manage the trade diligently.