Risk Management for Trading and Investing
Are you playing the market, or are you letting the market play you?
Everyone “knows” what risk management is, but not everyone knows what risk management is. Not everyone knows what it means to have proper risk management guidelines, much less follow the rules or concepts they “know” each day.
This topic is hard to get through without sounding preachy, but I’ll do my best.
What is proper risk management?
Risk management involves any analysis and actions undertaken to mitigate the uncertainty in a trading or investment decision. It’s taking control of the things you CAN control in the market. You can’t control the market's direction or know how much you will gain, but you can always be certain of what you stand to lose before making any decisions or taking any position.
That broad definition can be broken down into two groups to help create a framework within which to operate. Since this is a long and wordy topic, I’ll break it into separate posts.
They are Preparations and Executions.
Today I’ll cover the executions, and tomorrow, I’ll post the preparations.
Yeah, I know that’s backward; deal with it. :-p
Execution for Controlling Risk
Position Sizing & Stop Losses
“Stop Loss” is a 4-letter word to some folks. “Position Sizing” is a foreign concept.
They are both, however, crucial to the long-term growth of a portfolio. Losing is an inevitable conclusion in trading. The combination of both these execution items prevents consecutive losses and drawdown from ultimately being a net negative outcome.
When I encounter traders who have sworn off stop losses and ask why I typically get a few repeating reasons:
I don’t like losing.
I can’t afford them.
I would rather ladder buy.
I can wait for it to come back.
Manipulation.
I am not in any position to tell people that their reasoning is invalid, though I can ask questions that dig deeper into the root of these responses and provide some counter logic.
Who does like losing? Do you think you are losing because of the stop loss? Perhaps your trade idea wasn’t in agreement with the market conditions.
Why can’t you afford them? Are you having many trades stopped out? Perhaps your stop loss placement isn’t allowing enough room for the market to move up and down during your trade. Perhaps your trade idea wasn’t in agreement with the market conditions.
Everyone has their preferences, but consider your planning and initial position. Was your intention really to double down? If so, wouldn't it be less risky to start from the lower position first and not need to double down? If not, consider that your first market assessment has turned out wrong. What makes you now think your new assessment will be right? You are now approaching the market with a bias toward a successful trade outcome. Also, a subsequent wrong assessment will now compound the loss.
Patience is a virtue, but the market can and will outlast us all. It can remain negative likely longer than you can remain solvent. Anything can happen. How long are you willing to keep your capital locked up? Accepting a loss frees you for other, likely better opportunities. Also, if your position is on leverage you are paying interest on your positions, and in a long enough hold, your accrued fees can even make your breakeven price a loss when you close out.
A market doesn't exist without manipulation of some sort. We are all playing a game: small traders, large traders, whales, institutions, and governments. Different games, but forced to play on the same field simultaneously. You have to learn to play around and with the manipulation. You will get swallowed up if you can’t find a way to operate in the market or learn to avoid it.
While a stop loss can solve many problems associated with poor risk management, the underlying issue is often a matter of too large positions. Many of these traders against stop losses cannot determine how much they put into a trade or use the oft-prescribed 1% or 2% seen on various youtube videos or trading educational materials.
While the small percentage exposure of your portfolio is a wise choice, it’s not the whole picture. The amount of capital put into a position should be determined by the amount you are willing to lose of the portfolio with the trade. Don’t arbitrarily put 1% of your portfolio on the trade regardless. Evaluate where your stop loss should be and do the math to figure out how much exposure equates to a 1% loss if you are stopped out. This type of position sizing will equalize your risk across assets and timeframes. You can adjust your exposure based on the asset's volatility or market cap.
I don’t want to get too deep in the math in this post, and that will all be covered in-depth later on in Position Sizing and Stop Losses.
Create A Trade Plan
There should be a reason and a plan for everything you do. It is unlikely to have consistent success when everything is on a whim. Many simple questions need to be answered to help influence your future actions. Ponder these and think of your own.
How much money will I be managing? What exchanges will I be operating on? What do I want to trade? How often do I want to trade? What strategies will I be employing? How will I know to enter a trade? How will I know to exit a trade? What will I be doing with my profits? When will I stop because of losses?
This leads to another beneficial item, a trade journal. You can’t improve what you can’t measure. The simple act of recording each action you take can make a world of a difference to your long-term success but ONLY if you review it. For each position, at a minimum, you should record the time/date, asset, signal for entry (trade strategy), price of entry, stop loss price, and if you can, add some notes about the analysis. After each trade, at a minimum, record the exit time/date, signal for exit, outcome profit or loss, and if you can, notes on the trade result.
Excel is great for this, and there are tons of online resources. If pen and paper is your jam, that’s cool too, it’s how I started everything. I still have boxes of notebooks. Eventually, I moved to Rocketbooks, erasable notepads I can upload via a smartphone app with text recognition. Now my final form is Notion, and I’ll link to my trade journal that you can copy to utilize yourself if you’d like.
My review process comes around the end of the month, each quarter, and the end of the year. I’m looking to see what went well and didn't and how I performed as an analyst. It’s not just about reading over the stuff for reading's sake but to see how I am evolving as a trader. What can I improve upon? What do I need to give up on? Am I beating a buy-and-hold strategy? Am I outperforming the market indexes? Is there a strategy that did well over X time/date? Can I determine why that is and replicate it? Is there some period of heavy drawdown? What was going on during that period? Is it something in the markets or my life impacting my trading? Can I do something to diminish that impact? Do I trade better on X day of the week or X week of the month? If so, can I determine what is giving me the boost during that period? Can I adjust my position sizing to go heavier during that period to exploit my trading strengths? Is X strategy consistently outperforming Y strategy? If so, should I stop trading Y strategy entirely, or is there a particular time in the market where Y strategy is outperforming X strategy? If the latter, I can free up that Y strategy capital and devote it to other places until the market conditions that make it shine come into play. When reviewing my winning trades, are the assets continuing in the profitable far beyond my exit price? Is there something I can tweak in my exit condition to stay in those positions longer, or do I need to execute a different strategy entirely to catch that move?
There are a billion more possible evaluations to be made to improve as a trader, but none of them can be answered without proper documentation of your trades.
Backtesting
There’s no one way to trade profitably. There are many, but how do you know which strategy is worth the time to learn and implement? Trading without backtesting is like trading blindfolded. There is so much information you can know about a particular method, pattern, or indicator with just a little look at historical performance. Of course, past performance is not indicative of future results, but as statistics fans, we can reasonably assume there will be some continuity. Backtesting can be as simple or in-depth as you want to make it.
Simple Method:
Identify some conditions that you intend to trade.
Find that condition on the charts in the past as often as it has appeared for as much history as you have available.
Separately count the number of times it has led to a profitable and negative result.
Is it profitable more than half the time? Great!
When it wasn’t profitable, did they lose enough too much to outweigh the profit? If not, you have enough information to look deeper into this condition.
That’s not too hard, right? Heck. Just think of how much time saved and frustration prevented from learning some difficult method that ultimately sucks by a little bit of research.
In-depth Method:
just kidding; I’m not gonna go there in this post. At most, it means learning to program code and then test strategies or learn to manipulate backtests on different trading platforms or tradingview. If you do go that far, you’ll be better for it, but I can understand that type of commitment is not for everyone. Although Tradingview’s language, Pinescript, is fairly intuitive, you can do some decent backtesting. At least, it means finding preceded strategies in tradingview to review the backtest.
The more in-depth you go, the more information becomes knowable about your strategy. You can finely tune your approach. Say in X strategy you discover winning trades on average take 2 hours to hit profit targets. This may lead you to cut out of trades that have been open in profit for 3 hours but have not hit the target because odds suggest that it won’t and may turn back on you to become a loss. Say in Y strategy on the 1-minute timeframe with tons of signals, there have never been more than four losses in a row. This may lead me to wait to enter a trade until there have been four losses because, statistically, the next one should be a winner. Say in Z strategy, the avg winning trade is 5%, and the strategy has a smooth up angled equity curve. This may lead me to create an automated all-in all-out automated strategy with a fixed profit target of 4% because, on average, it should consistently achieve that, and the smooth equity curve means the wins were all around the same percentage, not a few sparse big wins speckled among many losses.
The possibilities are endless when you have concrete information to base your decisions on. Going the pre-coded tradingview strategy route, it will also help to learn a bit about what the strategy is doing so you can verify the signals and backtest. It’s also insanely easy to create a script that looks good but is pure garbage. Ideally, avoid black box systems (or strategies with hidden code) unless you are provided verifiable backtest results or have the means to do so yourself. I can duplicate many black box systems with my knowledge of backtesting systems and coding. Still, I skip over most of them because there are plenty of open and free ones that I can test that usually perform the same. Also, the more you learn about different methods and strategies, you see that most things are copies or tweaks of something else. There’s very little that’s new or innovative.
If a system backtest looks too good, it’s probably too good to be true. There are generally two backtests you will have to choose between. A higher percentage of winning trades with an average to decent profit (slow and steady wins the race) OR a lower percentage of winning trades but overall higher profit (boom but with many small busts). It’s rare to find systems with lots of accuracy AND high profits those are the ones to be speculative of.
One aside to backtesting that traps many new backtesters is called overfitting. You never want to create a backtest that looks too good to historical data. The more you tweak for market conditions, and add entry signal filters, and adjust trailing stops to make it fit the past for major profits and few losses, the less it can fit to the future. Your amazing system will only work when all those exact conditions of the past occur again in the future, which is HIGHLY unlikely. It’s ok to have losses. As I said earlier, losses are inevitable. You want a robust system that accounts for them and remains accurate and profitable.
How to Execute
In the following pages, we’ll dive deeper into these topics with small manageable steps to follow. This will create a base level of knowledge to build upon. The more you do all these things, the better you become at your new career.
Bonus Reading:
Good job! You made it. I know that was a lot. See you in the next post.
@theprivacysmurf
loved this what a gem
Awesome post. I make so many “avoidable” mistakes...backtesting seems to be the best way to create a plan that will avoid so many psychological pitfalls.