Sovereign debt, falling gold prices, Euro worries...there is a lot of talk in the news about risk. However, as a trader, risk can mean something different. There are two types of risk we must face in the markets. The first is considered as an opportunity, as seen in the current risk issues facing the global markets that I highlighted above. This risk in the world makes for increased volatility that we can trade on. The second risk we face is the risk of loss in our trades. In fact, when we are trading, the amount of loss we will suffer is the only thing we can control. We cannot control whether we will win or lose in the trade as we cannot control the direction of the markets themselves.
To most traders, risk management means simply setting stops. However, there is much more to managing your risk in trading. You wouldn't drive onto a bridge if you have noticed that most of the supports have crumbled would you? How about walking onto a frozen lake after seeing a "Thin Ice" sign posted and several cracks showing in the ice itself? Of course not, that is because you observed the environment and realized that it was too risky to proceed.
We need to observe the same discipline when we are trading. To analyze risk before trading, we must look at the current market environment, the security's environment, and the trend. Are we in a danger spot that would preclude us from taking a trade? No one is forcing us to make every trade that we see. Suppose the markets were bearish, your security has just released disappointing earnings and is near resistance on your trading and larger time frames. Would you take a long trade just because prices moved up slightly after a bullish hammer candle? Most likely you wouldn't. Even though you have a short-term bullish signal, the overwhelming bearishness of the markets tells you that the environment is risky for a long and the reward isn't large enough to endorse a long position.
We need to mimic the most successful traders in the equities markets, the brokers. The brokerages have separate departments called compliance to analyze risk and ensure the brokers and traders are staying within guidelines set forth by the broker and regulation. As a trader, you are the trading desk and the compliance desk, but you must perform both of these functions to be successful in the markets. Many traders can plan a trade, but not all have the ability to analyze the risk and manage the risk in a manner that ensures their survival as a trader when things go wrong. And believe me, they will from time-to-time.
You may remember the older radios with analog dials on them. Before digital came into our lives, we had to adjust radio stations and volume by turning the knob. Well, the trader's risk radio works similarly. On this radio we have three knobs that we can adjust to increase or reduce the risk we face when trading the markets. Only by finding the right balance will we trade to the best of our abilities.
The first knob is similar to one we would find on a normal radio, frequency. In trading, frequency refers to the number of trades we will take. The issue with many traders is that they will keep this knob turned up way too high and take trades with only a marginal chance for success. Successful traders have the discipline to turn down the frequency and take only those trades that meet specific criteria outlined in their plan and offer a high probability for profits. As a new intraday trader, you should limit the number of trades you take per day to less than four. This will force you to look for the right opportunities to trade rather than jumping in on any small move in the markets. Remember, even if you miss an opportunity, there is another one coming along very soon.
The second knob is duration, or the amount of time spent in the trade. The longer you spend in a trade, the greater the chance for adverse price movement. When we turn down the knob to smaller time frames, we have less profit potential, but also much less risk. Think about what can happen to a stock position over the course of an hour. Then imagine what could happen to that same position if you were to hold it overnight, or even over the weekend. Right, you are exposed to potential gapping against you and have little to no protection. Trading on smaller time frames reduces the risk we face in our trades.
This knob should also be turned down when overall volatility in the markets rise. Rising volatility causes more drastic price swings. As a new trader who is unaccustomed to trading these swings, you are best served by reducing your exposure to them by trading in smaller blocks.
This leads us to discuss the most important risk control knob, volume. Volume for a trader is the share size we are taking per position. Obviously, most traders want to profit as much as possible, but by taking larger share size, we are also increasing our risks. Volume should start at demo, with no money at risk. After successfully practicing what you have learned in the Professional Trader (Foundation Course), you may increase your risk to 10 shares like you traded in class. If you are doing well, gradually increase your share size.
The key word in the last sentence is gradually. Many traders feel they must go from 10 to 100 shares, or 100 to 1000 shares. This increases your risk ten times! You are much better off by no more than doubling your share size or risk for every step, and only do so if you are achieving a positive win/loss ratio. When you risk more money in a trade, there is a psychological effect that you will notice. Watching profits and losses increase exponentially can wreak havoc on a new trader's psyche. This may cause you to panic and exit positions too soon or to hold onto losers as you become frozen with fear.
If you are not trading well at any time in your trading career, you should immediately tune the trader's risk radio. First, reach for the volume and reduce your share size. Secondly, be more selective in your trades and turn down the frequency. Lastly, you can also reduce the duration of trades to offset volatility. Tuning the risk radio correctly will ensure all your trades play a happy tune you'll love to sing along to!
Have a great day.
Disclosure: Long and short