How to start Day Trading A Funded Account ?
Chapter 4
Risk Management
The most important thing to know for a trader is how to manage risk. Anyone who is serious about starting off a trading career needs to make this his or her priority, for traders all around the world rise and fall for it and by it.
Typically beginners will dedicate all their focus to indicators and trading strategies and that is a mistake.
Sure, a good strategy can help a trader but if that trader doesn’t manage his risk properly, he could lose his pants even with the best trading strategy in the universe; believe me, I have witnessed crazy things like this my whole life.
There is no way to avoid risk in trading. Every single trade could – theoretically speaking, at least – turn and end up as a losing trade. The first key to risk management in trading, then, is for a trader to determine how much he’s willing to risk per trade and his win-loss ratio.
“And how do I know how much I’m willing to risk?” I hear you asking.
There are two main ways, one is automatic and one is mental, the idea is to combine both.
- The 2% risk – The idea of the 2% risk is that you always risk 2% on each trade.
For example, if you have $10,000 in your portfolio, your risk would be $200 and your take profit value would be of say $400. If you do pocket that trade, your new balance will be $10,400 which will allow you to increase your risk in dollar terms (to $208 while keeping your 2% risk rule.
- Mental risk – Here the trader stops for a moment and asks himself how much he can bear to risk in any given trade without that risk affecting his decision-making.
Truth is, risk appetite and tolerance are two very subjective elements of trading. People are different from one another and so are traders. They come from different backgrounds and have different levels of experience. Some traders have a much larger portfolio in their accounts than others and can afford to trade a little more aggressively. Some traders may just be trying to grow their savings little by little and are not willing to take risks more than is necessary. Others may be in the opposite situation and might be trying to grow their capital as quickly as possible and might be willing to take on a little more risk. Possibilities are endless when you think about it.
Mental risk management is not a one-size-fits-all kind of thing. It’s more like Cinderella’s slipper; each person must have the right fit.
There is no point for a trader to open a position and leave himself exposed to a large risk only to start having second thoughts at the first sign of a tiny drop. Whatever the weather, a trader should not risk any more than 2% of the value of his entire account in any one trade.
Risk appetite, risk tolerance and emotion go hand in hand. Once a position is open, your emotions are likely to immediately start interfering with your perception of risk. Price rapidly moving in your favor will “pump you up” and will increase your sense of risk tolerance. You might feel like “doubling down”, increasing your exposure and cranking up the risk level. Needless to say, that is all the ingredients a catastrophe needs.
On the contrary, price moving against you will make you doubt your decision and might end up pushing you to close a position that would have been otherwise very profitable.
Decide your risk level, the size of your position and your stop-loss before opening the trade and stick to it!
This leads me to a critical issue in risk management: How many shares should you buy?
Position size
To work out how many shares we need to buy to maximize our profit potential while remaining within our risk management rules is a simple equation.
To calculate it, you need to divide your dollar risk by the distance (in $) to the stop-loss.
Here’s an example:
A trader wants to buy a certain stock at $10 and he’s willing to risk no more than $100 on this trade. After studying his charts, he decides to set his stop-loss at the $9.50 level. Well then, how many shares should he buy?
The answer is simple. The trader needs to divide his chosen dollar risk ($100) by the change in price to his stop-loss (($0.50). 100/0.50=200
The trader can buy 200 shares and with a $0.50 drop to his stop-loss, he would be risking $100.
Risk-to-Reward Ratio
Now, let’s move on to the question of how we determine our risk-to-reward ratio.
Personally, a win-loss ratio of 3:1 is the minimum I am willing to accept to consider it worth taking any risk. A 3:1 ratio means I am willing to risk $1.00 for an expected gain of at least $3.00.
By keeping a ratio like this, any trader -even a beginner – is able to absorb and make up for up to three losses with each winning trade. It becomes evident that a trader could remain afloat around the break-even level even if using a strategy with just a 33% probability of success.
This may all seem very simple and straightforward but we have to remember the market is ultra-dynamic and in perpetual change. Like a wild beast, the market is unpredictable and has a mind of its own. A support or resistance line, big news, sentiment, anything can slow down price or even invert his direction whatever your ratio was meant to be. Keep that in mind.
All clear so far? Great. This leaves one last very important aspect of trading to talk about. Price target. What is it and where should you set it? Let’s find out.
Price Target
- Risk unit based – As we have already discussed, with this method we simply take our profit as soon as the stock price has reached the risk-reward ratio that we set in advance. Let’s say for example that we are trading on a risk-reward ratio of 2:1, entered a trade at a price of $13 and set our stop-loss at $12.70. In this case, our risk would be $0.30 and, to maintain our ratio at 2:1 we should aim for twice that same amount in profit ($0.30×2=$0.60) and we should then set our take profit order at the $13.60 level.
- Support and resistance areas on higher time frame charts – In this method, the reason to sell is based on historic support and resistance levels. This is what is called “looking to the left” of the chart on higher time frames. The reason for exiting the trade is triggered when the price reaches the closest support or resistance level.
- Time of day – With this method, there are two main reasons for exiting.
- Exit the trade before an important announcement. This is true for news that can affect the whole Market (i.e. Fed’s announcements) or news that can affect the stock you are holding (i.e. earnings report).
- At the end of the day. A day trader closes his trades up to ten minutes before the end of trading so as not to leave any position open and be exposed during the night to changes to which he cannot respond.
