Traders’ Survival Guide: A Primer On Risk Management


To succeed as a trader, you need to achieve two things.

First, find a trading edge.

Second, survive long enough for your trading edge to prove itself.

The second goal, the goal of survival, is known as risk management.

As a trader, you need a trading edge. But you also need to survive through drawdowns to see your profits. Hence, both goals are equally important.

The problem is that traders often place greater importance on finding a trading edge. The neglect of risk management and survival comes at a huge cost.

These guide will cover the essentials of risk management. If you put in the effort to manage your risk systematically, you will be ahead of most traders.

To survive in the market, you need to manage your risk in two broad areas: financial and psychological.

Financial Risk Management

There are two parts to managing financial risk. The first part relates to your overall financial health. The second part is about protecting your trading capital.

Personal Financial Planning

Trading is a capital intensive business. Moreover, trading profits are not guaranteed. Even for the best traders, the frequency and amount of trading profits will fluctuate.

What does this inherent uncertainty mean?

It means that you must conduct sound financial planning for yourself (and your dependents). If not, you will experience financial and mental stress that will affect your trading.

Many new traders think that they just need to save up enough capital to start a trading account, and they are ready to go. This is not true.

To survive as a trader, you must consider your overall financial well-being.

These are the key points you need to work through:

  1. Reduce your expenses
  2. Beef up your savings
  3. Track your sources of revenue

Do these three items with one goal in mind: reduce reliance on your trading profits. The less you rely on your trading profits, the more you can focus on trading well.

If you are looking for a book to kickstart your personal financial plan, take a look at this one. It’s based on the idea of condensing fundamental personal finance knowledge onto an index card.

Always remember that YOU are the trader. Your financial planning is essential to ensure your survival. It doesn’t matter if you get into financial trouble in or out of the market. If you do run into financial problems, your trading career will be short-lived.

Avoiding Trading Account Risk of Ruin

The key to preserving your trading account is to limit your losses.

Some traders might think stop-losses alone will protect your trading account. Some traders do not believe in having a stop-loss order. But what we are discussing here is not stop-losses.

While stop-losses is optional, limiting your losses is not. If you expose yourself to the possibility of unlimited losses, your survival is at stake. You risk destroying your trading account.

There are many ways to limit your losses. Let’s take a quick look at each method.

These methods are not mutually exclusive, and you can often combine them to achieve the best results.

#1: Limit Your Position Size

Position sizing is the most straightforward method to limit your losses. Ceteris paribus, the larger your position size, the more you stand to lose.

Position sizing is an effective method to limit your losses so that you can survive your strategy’s draw-down.

Risking 2% of your trading account is often cited as a rule of thumb. However, it’s better to derive a position sizing model from your expected performance. (See Monte Carlo simulation.)

#2: Use a Stop-Loss Order

For a technical trader, a stop-loss order is a potent risk management tool. You can use price patterns and S/R levels to set logical stop-losses.

With a stop-loss, you can work out how much you stand to lose with a given position size. Use it together with your position sizing model, and you will have a greater chance of survival.

However, there is an important caveat that many traders miss. Stop-losses are not guaranteed.

For traders operating on the daily time frame, the market might gap over your stop-loss. In that case, you risk incurring unexpected large losses.

Even for day traders, a lack of liquidity might cause your stop order to suffer from massive slippage.

Under such circumstances, your loss is only constrained by your position size. (This is why position sizing is so important.)

It’s true that stop-losses are not perfect. However, they remain a powerful and useful tool to manage your risk in most situations.

#3: Buy Insurance With Out Of The Market (OTM) Options

The idea here is to hedge your position with cheap OTM options. These cheap OTM options will likely expire without value. But they will protect you against any catastrophic adverse market movement.

For example, you can buy OTM put options to hedge a long position against a market crash. When the market crashes, you will lose money on your stock position. But at the same time, your put options will increase in value to compensate for your stock position loss.

In essence, this method creates a spread position using options. Click here to learn more about using OTM options as insurance for your trading positions, or check out Michael Sincere’s book on options below.

#4: Employ Long Options Positions

I prefer this method when I swing trade and hold overnight positions. Instead of buying the underlying stocks, I choose deep in the market (ITM) call options with high intrinsic value. For short positions, I use put options.

The advantages of long options positions:

  1. Potential loss limited to the options value
  2. Mitigate gap risk
  3. Withstand whipsaws (due to absence of traditional stop-loss order)

Of course, this approach has its challenges. Unlike stocks, options expire. You need the market to move favorably before the options expire. On top of that, for best results, you need to manage your trading positions actively.

Click here to learn more about using deep ITM options instead of stock positions.

WARNING: Selling Naked Options

Selling naked options exposes you to unlimited losses. You may make regular small profits, but one bad trade has the potential to wipe out your account.

There are ways to manage this risk, but they are not foolproof.

Click here to learn more about the dangers of selling naked options.

Psychological Risk Management

To survive as a trader, you need more than your financial capital. You need to preserve your psychological capital as well.

Psychological capital is a broad term referring to your willpower and confidence to trade in a disciplined manner.

Limit The Number Of Trades You Take

Here, I am talking about restricting the number of trades you make within a given period. (e.g. three trades a day)

Some traders think of placing a cap on the number of trades they can take as a form of financial protection. Others think of it as a limitation on their potential profits. Hence, depending on which camp you’re in, you may or may not want to limit your number of trades.

But this line of thought obscures the real purpose of this trade limit.

The actual impact of limiting the number of trades you take is psychological. Willpower is a limited resource. Taking each trade requires serious analysis, focus, and discipline.

Limiting the number of trades will ensure that you take only the best trades with your best effort. This circuit breaker is of particular importance after consecutive wins or losses. Hubris or revenge mindset might take over, and things will run wild.

Let’s assume you have a sensible position sizing model. In that case, you are more likely to deplete your psychological capital first. You are more probable to become mentally exhausted before your trading account runs the risk of ruin.

Hence, the real aim of limiting the number of trades you take is to protect your mind. (And indirectly your trading capital.)

Note: This above discussion applies mainly to discretionary traders. For system traders, instead of limiting the number of trades, a more relevant goal is to monitor your trading system.

Aim For The Right Process (Not Performance)

Your trading results over a given period is a function of your strategy and the market’s price action.

As you cannot control the market, your trading result is not something you can control over the short run.

Hence, aiming for a fixed profit each day is untenable. If you do so, you are ignoring the market. In a matter of time, as you try to hit your ideal profit level, you will start to overtrade. That spells disaster.

Thus, you should focus on following the right process to execute your strategy. Concentrate on the reasons for taking each trade, and not their outcome.

If you have a trading edge, this is the best approach to stay alive until your profits show up.

Conclusion

Manage your financial risks:

  1. Achieve good personal financial habits for a sustainable trading career.
  2. Limit your trade losses to preserve your trading account and avoid the risk of ruin.

Manage your psychological risk:

  1. Restrict the number of trades you take to prevent making bad trading decisions.
  2. Focus on your trading process and not results to stay on course.

Let’s recall. To succeed as a trader, you need to

  1. Find a trading edge
  2. Survive long enough for your trading edge to prove itself

This guide aims to help you with the second goal: to survive long enough to benefit from your trading edge. Risk management in itself does not offer a trading edge.

As risk management is not linked directly to a trading edge, it often appears unsexy to traders. But consider this:

Assume that you have a trading edge – a strategy that produces positive expectancy.

Do you want the trading edge to go to waste by going bust? Or do you want to make the most out of the trading edge by staying in the game as long as possible?

For traders who know how to trade, survival is the only game.

This is why I spent an entire chapter in my course covering a risk-based approach to trading. It discusses financial, psychological, and operational risks and their inter-relationships. Click here to learn more about the course.

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