Risk management

The one idea

Trading is a long series of uncertain outcomes, and a trader who survives long enough for an edge to show, or long enough to learn one, has to make every outcome survivable. Every rule of risk management is a way of capping what one bad outcome can cost. The rules are dull, they do not improve any single trade, and they are the difference between the accounts that are still open after a year and the majority that are not.

The rules

• Decide the maximum loss per trade as a share of the account, one or two percent for most people, and size every position from it. The position sizing article gives the method.
• Place a stop loss on every position before it is opened, at the level where the trade is wrong, and never move it further away.
• Cap the total risk across open positions, because several trades in correlated pairs, long EUR/USD and GBP/USD and short USD/CHF for instance, are one trade in the dollar. Five percent of the account across all positions is a common ceiling.
• Set a daily or weekly loss limit at which you stop trading, because the trades taken after a run of losses to win it back are the worst trades most people ever take.
• Use leverage that the position size implies, not the leverage the broker offers. A properly sized position rarely needs more than 1:10.
• Trade with an entity that gives you negative balance protection, and keep no more with any broker than its regulation protects.
• Keep a record of every trade, including the reason for it and the result, because the record is the only evidence of whether the approach works and where the losses come from.

The arithmetic behind the rules

The reason the per-trade risk is small is that losing runs are certain. A trader who wins half the time will have a run of five straight losses roughly once in every thirty trades and a run of eight about once in every two hundred and fifty. At one percent per trade, eight losses cost about eight percent of the account; at ten percent per trade they cost more than half, and recovering from a 57 percent loss requires a 133 percent gain. The rules exist to keep the account on the flat part of that curve.

The mistakes the rules prevent

Adding to a losing position to lower the average price, which turns a small planned loss into an unbounded one. Removing a stop because the market is about to turn. Doubling the size after a loss to get it back. Trading through a news release with a position that was sized for a quiet market. Holding a position over a weekend with a stop that cannot protect it from a gap. Each of these is a way of taking a risk that was not decided in advance, and the rules are there to make the decision once, calmly, rather than every time in the moment.

Risk beyond the trade

The trade is not the only risk. The broker can fail, which the client money article covers. A platform can go down in a fast market, which is an argument for knowing the broker's phone dealing line. A payment method can stop working, which is why the way in should be a way out. And the trader's own judgement is worst when it matters most, which is why the rules are written down. The market volatility article covers the conditions under which every one of these risks rises together.