Risk Management for Trading
Trading crypto-currency is a gold rush. While selling shovels is traditionally the best way to wealth in such a scenario, doing wise investments is essential once you have some money. I consider trading an entertaining and challenging pastime. Maybe the most important aspect of trading is risk management. While resources like BabyPips provide great learning material, their section on risk management is confusing. I believe, the biggest issue is that they approach the topics in the wrong order, so here is a better introduction to risk management for traders (crypto or forex or otherwise).
Why Risk Management?
You can have a streak of luck. You can also have a streak of bad luck. It even happens to experienced professional successful traders that they have losing trades 10 times in a row. Without risk management this could deplete your budget and the game is over. The most important goal is to stay in the game. As long as you are still playing, you can make up for your losses.
If you lose 10% of your money, it means you have to win 11.1%. If the budget was $1000 and you lose $100 (=10%), then you have $900. $100 is 11.1% of that. This means losses hurt more than wins of the same size. This becomes even worse with larger percentages. If you lose 50% of your budget, you must double your money to make up for the loss.
The rule of thumb for new traders to risk at most 1% of the budget per trade. If you lose 10 times in a row (not unlikely) and lose 1% each time, then how much have you left? Still 90%. If you risk 2%, it is only 81% of the initial budget. You have to win 11% or 23% to make up for that. Even if you lose 100 times (unlikely) in a row with 1% risk, you still have 37% left.
Experienced trader may use 2% at times. Traders who take a risk of 10% disappear quickly.
Convinced of the 1% rule? If yes, good for you. If not, the end of this article shows you how you calculate your personal perfect risk. For now, assume the 1% rule.
Ok, only risk 1% of my budget. Does that mean I can only invest 1% of my budget per trade? No. Only if you plan to hold until your investment is worth nothing anymore. If your trading strategy is buy bags of altcoins and keep them until they are worth 100x as much, then it really is that simple. Alternatively, you may plan to exit before your investment goes to zero, then you can invest more, but let’s slow down a little.
We assume you know your total budget. It does not matter if it is $100 or $100,000,000. The essential point is to have a given budget freely available. Do not use loaned money, which you have to pay back at a deadline. Do not use your retirement money. Consider your budget as “play money”! If you are emotionally attached to that money, these emotions will bite you. You want to be a chilled rich statistician, not a passionate poor gambler.
Next step is to look for a trade. It does not matter if you do day, swing, or position trading. You have tools like fundamental, sentiment, and technical analysis to find trades. Right before you enter a trade, there is an essential calculation to do: Decide entry price, stop loss, and risk size.
Ok, risk size is easy. We already know that we will pick 1%.
The entry price is also easy. It might be the current market price or the limit you set for your order.
Now, stop loss: It is essential that you know and decide a stop loss before you enter a trade. There is another rule that you are not allowed to widen your stop loss afterwards. You can move closer to or beyond your entry price to secure wins. The other direction is absolutely taboo.
How to pick a stop loss? Technical analysis is the only available method apart from randomly picking something. You will probably use something like “beyond the next support (or resistance) level” or “the other side of the trendline we just broke”.
Now that we have the four ingredients for risk management: Budget size, entry price, stop loss, and risk. Time for the calculator.
Now we calculate how much money you are allowed to invest in this trade.
Position size = (risk*budget) / (entry price-stop loss)
For example, if you have a budget of $1000 and want to buy Bitcoins for $2300 with a stop loss at $2200 and a risk of 1%, this means: Position size is (1%*$1000)/($2300-$2200) = $10 / $100 = 0.1. You are allowed to buy 0.1 Bitcoins for this trade.
Another example: Same risk, budget and entry price, but our stop loss is much tighter at $2290. Position size is (1%*$1000)/($2300-$2290) = $10 / $10 = 1. Nice, we can invest more, which means we win more, if the market moves in the right direction. We still only risk 1% of the budget. However, we also increased the risk that our trade will be stopped outdue to some random wiggling. If you set your stop loss too tight, your win rate suffers. In volatile markets (like Bitcoin and altcoins even more) stop losses need to be larger than in stable markets.
Also, wait a moment. We are allowed to buy 1Ƀ, which costs $2300, but our budget is only $1000? At this point margin trading can be used. This comes with additional fees and risks, though. Think twice before you go down that route. Also, stop losses so tight are usually only available to day traders. Swing and position trading usually use wider stop losses due to the market’s volatility that margin trading is not necessary.
All this risk management calculation combined with margin trading a fundamental effect: Volatility does not matter. In markets with a high volatility, you must use wide stop losses. With low volatility, you simply take larger positions.
For shorts, the formula must be changed a little. The last part is (stop loss-entry price) instead.
This calculation does not include fees, but usually they are insignificant to the risk you take.
You have to make this calculation before every single trade! Even if you do, you will experience excruciating drawbacks, but without risk management, it will destroy you. Your guts will scream at you to take larger risks, because you are soooo sure about your prediction. Angels will sing to you to widen your stop loss. Devils will seduce you to type in larger position sizes. Stick to the math. Become the rich statistician.
Before you enter a trade, you also should have a target price in mind. It should be a multiple of the risk. If you risk 1% of your money, the potential win should be something like 3% of your money. The absolute minimum should be a ratio of 1: For a 1% risk, you can increase your money by 1%. I would not consider a trade with a lower ratio.
This does not mean you will always reach your target or lose. You are allowed to trail your stop loss or exit early manually. Still, the target should be feasible considering the volatility of the market you are in.
Here is an example trade, which would have gone well:
How much risk did I just take?
Ok, inevitably you did diverge from the plan. You forgot the calculation. You entered a trade without due diligence. Whatever. How much risk did you just take?
You know your budget, entry price, and position size. Quickly come up with some stop loss. What is the risk?
Risk = (position size*(entry price-stop loss)) / budget
For example, I bought 0.3 Bitcoins at $2500 for with a budget of $1000. My stop loss is at … uh … $2345. This means the risk is (0.3*$155) / $1000 = 4.64%. Oops.
Now for some goodie which is not practically useable, but the math is sound. Why 1% risk? It is only a rule of thumb. Is there a perfect percentage? In theory, yes there is. We can use the Kelly Criterion. The formula is simple:
Risk = p-((1-p)/r)
Getting those variables p and r is hard. You have to know your win rate p, which is how often you reach your targets. You also need the win-loss ratio r, which is the average win per trade.
For example, if you win 47% of the time and you win 117% your investment on average, then your perfect risk is 1.7%.
In practice, you don’t really know p and r that precisely, so just stay with 1% risk.
I made myself a spreadsheet, where I can enter the parameters and it computes the position size (or risk) for me. This way it only takes a few seconds per trade and I know I will survive. Make yourself such a spreadsheet. Do not ask for mine, you will want to customize it anyways. It is also safer and more informative to do it yourself.
Good luck in the markets!