In trading, there are many different ways traders look to control and manage their risk.  Before we look at those ways, let’s define what risk is and why it’s important to you as a trader.  Risk is defined by Investopedia as:

“A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take on, the greater the potential return. The reason for this is that investors need to be compensated for taking on additional risk. ”

In other words, risk is the amount of capital you’re investing, and the amount of money you’re willing to lose in order to earn a return on your initial investment capital.  If you enter into a position without a stop loss, then your risk would be the total amount of money invested.  However, if you implement a protective stop, then your risk could be measured by the amount of money you could potentially lose if the market moved to the price in which your stop is standing.

Now that you understand what trading risk is, let’s take a look at the different ways traders look to manage their risk.  As I mentioned earlier, using a protective stop is a widely understood way to cut your losses short.  Not only can you protect yourself if the market goes down when you’re in a long position, but you can use buy stop losses if you’re short the market.

Getting in a trade that doesn’t hit your stop is just half of the equation.  Beyond that, you need to define when you’ll take profit.  It’s possible to get into a good trade, but not take profit at the right moment, which could turn a winning trade into a losing trade.  Traders use profit targets in many different ways.  Some traders use automated profit target orders, while others use trailing stops or some other strategy to lock in profits.

This last way of managing risk is misunderstood by many traders.  Position sizing means controlling your risk through managing the size of your investment.  Let’s look at an example:  You typically trade ten contracts on the S&P 500 E-mini futures contract with a hard stop of 2 points, or $100 per contract.  If your trade hits the stop on a full load of contracts, then you’re loss before commissions would be $1,000.  But let’s say instead of getting in with 10 contracts at one time, you decide to put on 5 contracts with a 4 point stop.  What would your loss be if the trade went against you in that scenario?  Well, $50 per point x 4 points equals $200 per contract.  If we’re trading with 5 contracts, that would mean we’d have a net loss of $1,000; the same as the first scenario.

So why would a trader want to trade with less contracts and more risk?    The benefit to scenario #2 is that you can get into a position with less risk on the table initially, let the trade develop further, then decide if you want to place more contracts on the table.  As you scale into your position, you could reduce or eliminate the risk as the trade moves in your favor.  By using this tactic, you are essentially increasing your winning potential while simultaniously reducing your stop size.  In other words, you’re increasing your chance of winning, stacking more chips on the table, and reducing the risk all at the same time!

Managing risk through position sizing is fairly simple, but takes practice to develop a plan that is consistently profitable.  Scaling in and out of trades can help put the odds in your favor and reduce risk, but it is not a substitute for a solid technical trading strategy and discipline.  You must combine a trading system that gives you an edge in the market, with a pre-determine risk management plan that gives you a positive expectancy.

There are many ways to manage risk.  No matter what form of technical analysis or risk mangement techniques you use, it’s vital that you stick to a plan that fits your own personaility and risk tolerance.  You can try an immulate other traders, but ultimately you’ll do best with something that’s inline with what’s comfortable to you!

Stay profitable,

Chris Dunn

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