Will risk management save your trading account ?

Using trading software can entail serious losses if you’re not careful enough. This can be avoided with a good risk management strategy.

Money management allows traders to control the risk exposure of their trading accounts and optimize their performance. In a field like trading where psychology is central, money management rules will often make the difference between winners and losers (provided they are applied consistently. 

It is not uncommon for good trading strategies to fail due to lack of proper money management. By developing a set of coherent risk management rules, traders can precisely anticipate the risks to which their money will be exposed, and work more serenely to build their performance.

How to have an effective trading strategy

Successful trading is based on three aspects :

  • a good trading strategy
  • good self-control
  • good risk management 

Creating a good strategy

Stock exchange investment is complex. No expert can claim to have found the best strategy to win every time. However, success often depends on a real strategy instead of navigating blindly.

Various strategies that can be implemented before starting. Copy trading on the sites of the best brokers is one example. Market timing and taking long term positions are also proven strategies.

Having good self-control

Fear, greed, and even recklessness or overconfidence can be detrimental to an investor's success, especially when you are just starting out. These feelings can lead you astray with every decision by diverting you from good logical reasoning. Sometimes they can even lead you astray from a plan you've already made.

Implementing good risk management

Risk management consists of setting limits that should not be crossed. Even the best strategy is not immune to the stock market volatility. In the same way, investors are not safe from their own feelings. Note that in the context of copy trading, money management protects you from the errors of the traders you are imitating.

What is risk management and why is it essential ?

Even the most successful investors don’t always come out ahead of their investments. This is not even true for traders who take long term positions in quasi safe assets. Most investors alternate good and bad results. Their secret to long-term success is to accumulate more profits than losses. One of the techniques to achieve this goal is risk management or money management on trading accounts.

Trading is essentially about taking calculated risks. To be successful in the long run, traders must take care to control their risk exposure, thus getting a good return on investment without putting themselves at risk. Money management enables traders to:

  • manage transaction risk 
  • maximizing gains 
  • minimize losses

In short, the goal is to optimize the risk/return ratio of a trading account while taking into account the trader profile.

Although almost all traders are aware of the benefits of good risk management, not everyone follows it to the letter. This is because it is difficult to define these rules, to apply them to every trade, and to be disciplined enough to follow them in all circumstances (even and especially in the case of a losing position). As the table below shows, the damage caused by poorly controlled trading losses can be very difficult to overcome...

Percentage of capital lostPerformance required to recover lost capital25%33%50%100%75%400%90%1000%

The bigger the initial loss, the more difficult it will be for you to recover. A loss of -50% will require a performance twice as important, or even more +100% to return to your initial balance! Prevention is better than cure, because whatever your level of trading, recovering from big losses is not easy. 

Leverage (a credit investment capability offered by most online brokers) means losses can mount very quickly at the slightest upturn in volatility. A comprehensive risk management system is therefore essential.

Sometimes even the best risk management system in the world fails, especially when the trader stays in position when the market closes. The trader is then exposed to the risk of a "gap", i.e. the risk of seeing the market suddenly "shift" when it reopens. To avoid this, it is therefore better to limit the use of leverage, but also, and above all, to avoid staying in position when the market closes. An approach such as day trading can simplify risk management.

4 tools to manage your risk exposure

One of the first (and most important) decisions a trader has to make is how much risk they are willing to tolerate. There are several tools that can help here. 

The Stop Loss

The Stop Loss order, as its name suggests, allows the trader to cut losses in a trade. By placing a Stop Loss order when entering a trade, traders can control the maximum loss they want to be exposed to (either by adjusting the Stop Loss level or by changing the position size). The closer the Stop Loss level is to the entry point, the lower the risk and vice versa. When the market is moving in a favorable direction, it is possible to opt for a trailing stop loss that follows the market and protects the trader's gains as it moves.

Traders can also set loss limits (daily, weekly or monthly) which will function similarly to a stop loss. Alongside monetary values, these rules can also be expressed in the number of losing trades (consecutive or not). To know where to place their stop loss orders, traders usually rely on technical analysis.

Mathematical expectation

Mathematical expectation is a probabilistic concept. It represents the average expected outcome of a trade, and is the sum of the average expected gain multiplied by the probability of gain and the average expected loss multiplied by the probability of loss. The important thing for the trader is to have a positive mathematical expectation. Indeed, even a strategy with a 99% success rate will be of little interest if its mathematical expectation is negative, since this could mean that the remaining 1% of trades are likely to cause very heavy losses.

Value at Risk (VaR)

Value at Risk is a measure of the maximum loss to which an investor is exposed. It is based on three factors:

  • level of confidence 
  • time horizon 
  • distribution of returns (assumed to follow the Normal Law). The trader can thus determine (with a confidence level of 99.99% for example) the maximum loss that they could record during a given period of time (over a month for example).

The Maximum Drawdown

The Maximum Drawdown is the maximum decline recorded by an asset or a trading strategy after reaching a high point. It is a historical figure that allows us to estimate the maximum extent of future declines.

Risk/Reward : what are the risk ratios ?

Good investors therefore alternate between profits and losses. The goal is to limit losses to a more acceptable level so that you can continue to trade and increase your chances of profit. A Risk/Reward or Risk/Return ratio is 2:1. In other words, in the first case, you expect to earn twice as much as you stand to lose. Therefore, for binary options, the risks are too great. In fact, the Risk/Reward ratios for binary options are less than 1:1, around 0.75:1. For a beginner, the acceptable ratio is 3:1 according to the experts.

Two indicators to optimize your risk/return ratio

When assessing your money management, you need to focus on more than loss control. Performance must be attractive in relation to the risk taken.

The Sharpe Ratio

The Sharpe Ratio is the net return per unit of risk. It is calculated by taking the difference between the return and the risk-free rate and dividing the net return by the number of risk units (expressed as a standard deviation). By comparing the Sharpe ratios of two strategies with different levels of risk, it is possible to select the best performing strategy (the one with the highest Sharpe ratio, i.e. the one with the highest net return per unit of risk).

The Profit factor

The profit factor is obtained by dividing the sum of the gains by the sum of the losses. Thus, the more lucrative the strategy, the higher the profit factor. This indicator allows you to measure the quality of your performance. Thus, it is not necessarily the strategy with the highest performance that will be judged as being of better quality, but rather the strategy that best manages to generate gains while controlling the level of losses.

How to know if your risk management is good

To become a good investor, you need good risk management. This means:

  • having a good risk management strategy, making sure it is effective and sticking to it
  • analyzing everything without stopping
  • seeking above all to minimise losses, not maximise gains
  • seeking to continuously improve your risk/reward ratio
  • staying humble by realizing that other traders are also smart 
  • having set up your account properly by defining: Stop/Loss, Maximum Drawdown, position size, etc.
  • staying calm and acting with discernment
  • diversifying your asset portfolio.

How can you improve your trading risk management strategy ?

With automatic trading, it is now very easy to set your stop loss levels. Risk and performance indicators are also easy to calculate and can be provided by most trading platforms. On the other hand, this information is useless if the trader does not follow their own risk management rules at all times.

Faced with the turmoil of the financial markets, the human mind finds it very difficult to resist emotions and remain impartial. The more hours and sessions go by, the more difficult it is for them to discipline themselves. Sooner or later, many independent traders end up making a mistake and the financial damage can be irreversible. To avoid the pitfalls of human nature and work with a free mind, most traders today choose to delegate the application of these Money Management rules to an impartial entity: the machine!

The best trading applications are indeed equipped with this feature. On Aryatrading for example, you can set the percentage of your capital you want to use per trade, the risk/reward ratio you are willing to take, etc.