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Risk management is perhaps the most important factor in the long-term success of all traders. However, it is probably the most neglected part of many new (and some experienced) trader’s approach. When traders are focused on how the next trade can make them rich, they miss the fact that if they don’t manage their risk carefully, the next trade is far more likely to send them bankrupt. One thing is certain – the only people who survive for the long term in the financial markets manage their risk well. Those that don’t may as well blow their financial brains out! Let’s see what some of the experts have to say…

Dr. Van K. Tharp

“The key to success in the markets is to find a system with a positive expectancy and then do something that most people don’t even consider – trade it at a position sizing level that will allow us to survive and then thrive” ~ The Definitive Guide to Position Sizing

No Risk Management? You May As Well Blow Your Financial Brains Out!

Dr. Van K. Tharp
[email protected]

Most new traders don’t have a positive expectancy trading system. Without this they are doomed to failure and sooner or later (probably sooner) lose all their money. Once you have a positive expectancy trading system the next step is to manage the risk so that you can realize that expectancy over time. The trick is to understand what level of risk (or position sizing level) will allow you to survive with your trading strategy. This depends on the strategy, but in many cases it will be far lower than you might think. Many authors tout the ‘2% rule’ that says never risk more than 2% of your account on any one trade. In many cases this is actually way too aggressive. The vast majority of new traders would probably laugh at a trading coach who tells them to risk 0.5% of their account on each trade and tell them that is way too low to get rich…but the vast majority of new traders don’t survive – Food for thought!

Jack Schwager

“You don’t have to be a mathematician or understand portfolio theory to manage risk.” ~ The New Market Wizards

There are all sorts of complicated theories around about how to manage risk in your trading. You may have heard of VAR, Portfolio Theory, Risk of Ruin, Optimal F…all of these are complex to understand and even more complex to apply. I would even be so bold as to say they are probably useless for the private trader. To manage risk as a private trader you need to start by understanding a few simple things:

  • How much you will lose if you are wrong on each trade;
  • How much total risk you have in your portfolio;
  • How many losing trades you could have in a row;
  • The worst case scenario for your portfolio in an extreme market move.

If you have objectively looked at these and you are truly comfortable with the implications for your portfolio then you are off to a good start. But if you dismiss any of these things or resort to hoping / assuming that it won’t happen then it is just a matter of time will it comes back to bite you.

Dr. Alexander Elder

“The first goal of money management is to ensure survival. You need to avoid risks that can put you out of business. The second goal is to earn a steady rate of return, and the third goal is to earn high returns – but survival comes first” ~ Trading for a Living

Dr-Alexander-Elder

Dr Alexander Elder
www.elder.com/@Dr_A_Elder

So many traders come into the market thinking only about getting rich. But as Elder implies in the quote above, this is a mistake. We should all think about surviving first, and then move on to thriving in the markets. I learned so much more by trading than I ever did studying the markets from the sidelines. But in order to learn these lessons, you need to survive. There are several factors that improve your chance of survival in my view:

  • Having a profitable trading system that fits your personality, objectives and ideal lifestyle
  • Having a written trading plan
  • Risking a very small percentage of your capital on each trade
  • Limiting the number of trades you have open at any one time to cap the total risk you allow in your portfolio

Just remember, most traders lose money and eventually quit. Survival is a great objective for the first learning period of your trading. Managing your risk helps you survive.

Thomas-Stridsman

Thomas Stridsman

Thomas Stridsman

“In a well-working system you really have no idea about whether your next trade will be a winner or loser, you will be best off, in the long run, always and for each trade, to risk the same fraction of your account.” ~ Trading Systems That Work

Have you ever taken a trade and thought ‘I have a good feeling about this one’? Or looked at a chart and said to yourself ‘this is the perfect setup – it is going to be a great trade’? The problem is that these statements have the makings of disaster written all over them. As human beings we have many inherent biases which make us bad traders. One of the great things about trading systems is that they help us get past these biases by taking us out of the decision-making equation. When developed properly, every trade from a mechanical trading system should have an equal chance of success, and we really have no way of knowing which trade will make us money and which will be the losing trades. Because we have no objective way of knowing, the only logical thing to do is to treat EVERY trade exactly the same. This means take the same level of risk for every trade – even if it ‘looks like a good one’. I would take this recommendation one step further though. If you regularly find yourself feeling like one trade is going to be particularly good then it is important to document the reasons why you think that… then turn these reasons into trading rules that you can back test. Unfortunately if you are anything like me (human), you will find that most of your ideas actually don’t work and in fact give you the opposite of what you are looking for. But that is ok – That is why you use a trading system to begin with, because human intuition is just not that good at making trading decisions!

Robert Pardo

“Without the successful management of risk, there will come a day when we will no longer be able to trade because of the cataclysmic trading losses that have come from our unmanaged risk. The essence of good risk management is to risk as little trading capital as necessary so as to maximise profit.” ~The Evaluation and Optimization of Trading Strategies

Robert-Pardo

Robert Pardo 
www.pardocapital.com

I am constantly reminded of the truth of Pardo’s quote above from his excellent book ‘The Evaluation and Optimization of Trading Strategies’ because of all the stories of traders blowing up, brokers losing all their client’s money and even hedge funds blowing up and closing down. Two pieces of market wisdom that I like are:

  • ‘Your biggest drawdown is ahead of you’
  • ‘Somewhere out there is a trade with your name on it’

The essence of all of these, including Pardo’s quote above is that if you don’t actively and carefully manage risk in your trading then you will ultimately lose all your money. The really interesting part of this quote is ‘risk as little as necessary to maximise profit’. The a reason I like this is that it is the opposite of what most new traders would intuitively think – you have to risk LESS to make MORE. But most new traders would be thinking they need to risk MORE to make MORE. Great trading is often counter intuitive and this is a perfect example. When controlling your risk by reducing the amount you risk on each trade you will find that you can often make more money with greater certainty. The uncertainty of your trading profits increases as you increase the amount of your trading capital you risk on each trade.

The lesson is clear!

So this has been a discussion of risk management and quotes from 5 masters of the trading universe. Risk management is clearly one of the most important components of profitable and sustainable trading. Seek first to survive and then thrive in the markets. Do this by reducing your risk until you find the level which minimises your chance of blow-up and maximizes your chances of profit in the long run. All of these quotes came from books that I have read on my journey to successful trading. If you would like to quickly discover the top 10 trading lessons that I learned while reading 150 trading books, enter your details below to get my free report and video training.

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