Trading Journal #2: Risk Management (part 1)
Most (if not all) professional traders will tell you that risk management is the most important aspect of being a successful trader. Other factors such as patience, timing, and experience should not be discounted, but without proper risk management you can possess all of the above traits and still lose all of your money. Proper risk management not only prevents you from losing too much in a single trade, it also forces you to think about trades in a purely mathematical sense — allowing you to remove emotion from the trade and think algorithmically.
In this post, we’ll dive deep into risk management to give you a sense of how professional traders approach trading. There will be some mathematics involved, but we will keep it to a minimum and aim to provide a holistic overview of the concept to aid your decision-making process.
This will be one of several posts on the topic, and this post serves as an introduction to the topic, with more detailed and specific posts to come shortly.
Note: this post should not form the basis for making investment decisions, nor be construed as financial advice.
What is Risk Management?
Of course, the name gives it all away, but there’s more to this than meets the eye. If you google “risk management” you’re sure to get a plethora of hits that can dive deeper into the mathematics of risk management theory, but the math and theory of risk management can quickly become overwhelming.
Instead, let’s focus on a few core concepts. In traditional finance markets, there are various different sectors to consider when calculating risk. Because various traditional assets (including equities & bonds, commodities, manufacturing, etc.) are all interconnected and, to varying degrees, dependent upon one another; when building a risk profile for an asset a firm traditionally considers a wide variety of risks that affect each market.
For example, housing is dependent upon not just supply and demand, but also the price of commodities such as wood, transportation and logistics, federal interest and mortgage rates, default rates, consumer debt, and much more. All of these things can affect the broader housing market, and therefore must be considered when building a risk model.
The cryptocurrency markets have a few extra degrees of separation from the broader economy (for now). You might have heard that the price of Bitcoin is largely correlated with the Nasdaq and therefore during sideways or bear markets, trading BTC is like trading the NDX. While this indicates that Bitcoin is exposed to traditional market volatility, the fact that crypto never sleeps and trades 24/7/365 means that when traditional markets are closed, crypto continues to move.
As such, crypto traders are a bit more insulated from externalities that can affect specific asset classes. BTC trades like the Nasdaq largely because it’s traded by algorithms and funds that also trade the Nasdaq, but the fact that NDX is an index means that it’s more resilient than more specific asset siloes. Therefore, our risk management techniques can more greatly emphasize technical and fundamental indicators.
Part 1: Where do we begin?
One of the most obvious places to start is with our emotion — as stated in our previous post, when trading we want to remove emotion from the equation as much as possible. We need to be completely honest with ourselves: we are here to make money, and ONLY to make money. We are not believers, we are not bagholders, and we most certainly are not moonbois.
When we focus exclusively on the value of our portfolio in our preferred fiat denomination, we can better separate ourselves from our emotional desire for the asset to perform well. It is exceedingly difficult to properly manage your risk if you “believe” in your investment. Believing makes it more difficult to sell when bad news hits, or when an important trend is broken.
Once we’ve removed emotion from our trades, the next thing we need to focus on is learning when to trade, and more importantly, when not to trade.
Trade less to profit more
That’s right — one of the most difficult habits to form is to actually not trade. It can be tempting, especially during trending markets, to trade as often as possible. However, this is one of the quickest ways to lose money. Excellent traders will tell you that they are sitting on the sidelines over 90% of the time.
Why is it then that taking fewer trades can lead to being more profitable? A few reasons:
- Trending markets move quickly and rarely revert to their initial state, meaning you need to be early. If you’re not early, you’re late, and entering late means taking on additional risk with lower upside potential.
- Volatile markets are indecisive and can chop inexperienced traders to pieces before a real trend emerges.
- Overtrading leads to exposing oneself to unnecessary risk.
- Taking low R:R trades means you need to have a higher strike rate in order to be profitable in the long run (see the graphic above).
As you can see above, even if you are risking a very small percentage of your portfolio, you can get chopped to pieces if your trades are not successful. So how do you ensure that your trades are successful? That’s an impossible question to answer.
Instead, we want to focus on ensuring that enough of our trades are successful, and that the level of success is enough to continue to be profitable. You might be able to imagine a kind of “frontier” for the R:R one should aim for with their current strike rate, and this is a topic we will dive into in the upcoming Risk Management series in our trading journal, but for now let’s discuss position sizing.
How much to play with
When entering a trade, one of the most fundamental concepts to consider is the risk versus reward ratio, otherwise known as R:R. The ratio is simple: How much you risk, versus how much you stand to gain.
If you enter a trade for Bitcoin with a stop loss 1% below your entry and your take-profit level 3% above your entry, your R:R ratio is 3:1. However, if you’re consistently taking 3:1 trades but get stopped out 80% of the time, you’re still losing money. On the other hand, if you’re consistently taking 1:1 trades and only get stopped out 40% of the time, you’re still going to be making money.
Therefore, finding an ideal balance that suits your trading style is important. If you are making swing trades that take days/weeks to execute, it is smarter to look for higher R:R trades that are more likely to play out. There’s only so many trades you can make in one lifetime on that scale, so you might as well focus on maximizing your winners. Someone following this strategy may look to risk a bit more if the upside is much higher.
On the other hand, if you’re trading at a higher frequency instead you may be looking to make as many small winners as possible. Therefore someone executing this strategy will likely look to compound as many small wins as possible, risking little but also pursuing fewer “big winners.”
There is no hard rules regarding how much you should risk depending on your R:R ratio, but the idea is that the more you trade, the less you should risk per trade.
Just because you’ve started to reduce your risk per trade doesn’t mean that you’re automatically going to start being profitable. As mentioned before, you also need to maintain a proper strike rate in order to stay afloat.
In our next posts we will discuss more advanced strategies to not only manage position sizing, but also more advanced strategies to improve your strike rate and ensure that you maximize the number of profitable trades.