Trading risk management
Recognising and managing risk is an essential part of your trading strategy. As infamous hedge fund manager, Larry Hite, once said:
“Throughout my financial career, I have continually witnessed examples of other people that I have known being ruined by a failure to respect risk. If you don’t take a hard look at risk, it will take you.”
Now that we’ve covered the need-to-knows of risk management, it’s time to look at more advanced methods, including the Risk:Reward Ratio and the Sharpe Ratio.
What is the Risk:Reward Ratio?
Before taking a trade, you should calculate your Risk:Reward. This is mathematical equation where you divide the amount you may lose if the asset moves in an unexpected direction (risk) by the amount you may profit if the trade moves to our expected target (reward).
The risk:reward ratio is an equation which compares the expected returns of a trade against the amount you are willing to risk. It divides the amount lost if the product moves in an unexpected way (Risk) with the amount of profit that could be made when a trade moves to the expected target (Reward).
When you’re trading, you should look out for the following ratios:
The most popular Risk:Reward ratio is 1:3, but ideally no less than 1:2. The higher the ratio, the better the potential return.
How to measure risk performance
Trading performance relies on your individual tolerance for risk. A couple of steps can be taken to calculate risk:
- Deciding on a fixed amount of capital lets traders know how much to put at risk on each trade. The amount can range from £10-£1,000.
- Setting a fixed percentage for each trade
Example of ‘R’ in practice:
Below shows an example for when a trader buys FTSE (Financial Times Stock Exchange) at .7120, then decides on setting the target of .7180 as the reward level, with a 20-point potential risk as the stop level:
If you were to risk £100 per trade, then you would divide the value by stop amount:
£100 divided by 20 point difference = £5 per point
If the trade stopped out, you would lose 20 points, which means:
£5 per point x 20 point difference between stop and entry-level = -£100 (or -1R).
But, if the trade hits the target/reward level, you would make 80 points:
£5 per point x 80 point difference between entry and reward level = £400 (or 4R)
What is the Sharpe Ratio?
If you get a Sharpe Ratio between 2 and 4, it shows a trading system that has steady return and no huge changes in the account balance. It’s up to you to decide how you’ll trade…
Risk management is an essential part of your trading strategy. All trading involves risk, but by having an awareness of them, you’ll be able manage it effectively. As mentioned before, your risk management is unique to you, depending on your appetite for risk, the markets you trade in, and available funds. It’s important that you stick with your risk management strategy to avoid any unnecessary trading mishaps.
Risk management can help to reduce some of the emotions involved with trading. It’s important to recognise that trading can be a very psychological hobby – why find out more with our breakdown of the key feelings?