Basic Risk Management
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This article includes:
- What risk management is
- The importance of percentage calculations
- How to correctly size a trade
- When to risk more than 1%
What is risk management?
I’ve said before that a third of trading is managing emotions (covered in a previous article), a third of trading is using actual charts (introduced in my last article), and a third of trading is proper risk management.
One of the main things that makes a trader successful is risk management. This causes problems if a novice trader fails to understand the concept or doesn’t take the time to figure out the math behind it all. This concept is one of the most important for anyone going forward in learning how to trade. People who understand risk management might make bad trading calls or have the wrong ideas, but using proper risk management skills ensures that even the worst traders can stay alive in the market.
In this article I will show you how it all works, using simple examples and basic math.
The principles of risk management can be applied to any situation. People assess risks in their everyday lives without realizing it. Putting on your seat belt is a way of managing the risk of a car accident being fatal. Getting a yearly checkup at the doctor ensures that you aren’t risking your life and health. Even looking both ways before crossing a street, a piece of wisdom learned in childhood, is a form of risk management.
How does risk management apply to trading and cryptocurrencies? Many people manage the risk of losing all their capital by spreading their money around multiple exchanges, projects, or cryptocurrencies, just in case one goes down. Without taking the time to do some calculations, however, this is not an effective strategy.
The most important thing to calculate is if you take a loss, how much does it take to recover?
Percentages depend on the starting amount (i.e., not all percentages are equal)
The first thing to note is that a 10% decrease and a 10% increase on your portfolio are not the same dollar amounts. Many people think that if they start a trade at $1,000, and the price dips 10% down one day but up 10% the next, that they are back at $1,000. This is not the case. The difference is smaller with lower percentages, but it gets logarithmically intense. From my example:
Lose 10% on portfolio on Day 1: $1000 x .90 = $900
Gain 10% on portfolio on Day 2: $900 x 1.10 = $990
As you can see, the trade is now at $990, not back up to $1000. You may be thinking that 10 bucks isn’t much, but remember that this all scales. Instead of 10 bucks, think of the impact of losing $100 — or $1000 — or even $100,000.
As another, more obvious example of how equal percentage losses and gains don’t cancel each other out, let’s use 25% instead of 10%.
Lose 25% of portfolio on Day 1: $1000 x .75 = $750
Gain 25% of portfolio on Day 2: $750 x 1.25 = $937.50
Now you’ve lost $62.50 instead of a measly $10. How can you recover from the loss?
Fortunately for you, the math isn’t too complicated, and someone else has already done it for you. In order to gain back the lost money from a -25% hit on your portfolio, you need to gain back 33%. Here is a chart showing the percentage differences between the losses and gains.
As you can see, you don’t want to risk too much of your entire portfolio. Also remember that this is all based on percentages: You don’t need or want a fixed dollar amount for trading, because if you go lower, you get hurt more, and if you go higher, you lose out more. Changes to your portfolio should be based on percentages. The following chart shows the differences between fixed percentages and fixed amounts over time.
Using a percentage-based risk management trading style automatically leverages your gains to compound on each other, as well as deleverages your losses to maintain staying alive in the market.
How to correctly size your trade
Understanding percentages and knowing that the risk of losing out needs to be managed, people usually say to risk 1% of your portfolio per trade. Some do more, risking 2–5% of their portfolio. I will get to the reasoning for the higher percentage later, but first we must see how to risk 1% of your portfolio per trade.
People often get confused by this, thinking that this means only ever using 1% of their portfolio for a trade. This is definitely not what I mean. I’ll illustrate with an example.
Say you have $1,000. You want to risk 1% of it on a trade. First, do the calculation: $1,000 x .01 = $10. You want to risk $10 on a trade. Specifically, you are giving up $10 to enter a trade. You expect the worst case scenario from the start before you risk anything, and you can live with losing $10, ending up with only $990.
Now for some reason, people think you take this $10 and throw it all in a coin. Then, you have to buy into 100 coins to use your full capital. I got confused the first time I heard 1% of your portfolio and thought it was crazy until I understood what it really meant.
What the $10 actually signifies is when your stop loss gets hit. Stop loss is the price point where you say, “This is not going the way I want; I need out.”
When you hit your stop loss price, you need to get out of the trade, usually no matter what the cost. In this case, you’ve known that cost from the start — 1% of your portfolio or $10.
Let’s go further with the scenario. Starting with your portfolio of $1,000 dollars, you decide to go all in on a trade. This means you think the price will go higher, and not drop even 1% below your current price entry point.
Many people go all in and risk too much. In our scenario, here’s what you should do instead. The price is bound to fluctuate, even if you think it will end up higher than where you started. In order to allow even a 2% price fluctuation, you have to allow that in your trade. In practical terms, this means taking your portfolio number ($1,000) and dividing by the fluctuation you want to allow (2%). Here is the math to describe it.
$1,000 / 2 = $500 for the trade
To double check, let’s work backwards:
$500 x 0.02 = $10
$10 / $1000 = 0.01 = 1%
$1000 x 0.01 = $10
This means that you should only be placing $500 in the trade at the current price — leaving the other $500 on the side for another trade at a later time, allowing for a 2% fluctuation in price, and using your stop loss price of $10 as an indicator of when things get too risky.
The spreadsheet snippet below shows what happens if you consistently lose 1% with each trade (the worst-case scenario). Why only 1%? I recommend this for learning and getting used to the calculations.
If you have $1,000 dollars, make one trade every day using your entire portfolio, and lose 1% every single day, it will take you longer than 600 days to wipe your account down to a dollar. Using 1% ensures that you survive almost two years, and that despite being consistently wrong in trading, you will still be ahead of others who risk too much. This is why using proper risk management is key.
Now that you know to risk as little as you possibly can, here is the best-case scenario: what just 1% compounded can turn into after 600 days.
Yes, I’m going for wow and shock factor, but I hope it makes sense. Yes, those numbers are above $800 thousand.
This is not necessarily realistic; while money can be made every day, it’s hard to make the right choice every single time. Instead, this shows how strong risk management can be. Having the proper percentage of your portfolio risked every trade is what makes people last a long time even if they are wrong.
Remember, this example started with only $1,000. Little trades here and there will add up in the long run. It does not matter if one person has $100,000 and makes 1% (or $1,000 in one day) and another person has $1,000 and makes $10 in one day. Do not look at this as an hourly wage, or that it isn’t worth it. Gains compound on each other no matter how small. Remember that 1% compounded daily on $1000 dollars is more than $800 K in less than two years. You cannot say it isn’t worth it!
When do you risk more than 1%?
Risking more than 1% is the first thing that new traders jump to, which is what ends up hurting them. People become too eager to make big gains and get rich quick. Honestly, the more time you take, the more confidence you gain in yourself, trading, and in calculations. All it takes is one hasty wrong move to end up losing a lot in this space.
The answer to the question of when you should risk more than 1% is to use the other two important factors of trading: emotional management and charting. Emotion, as I continue to stress, is a third of the issue. You basically have to trade like an emotionless calculator robot all the time. Once you know how to master or overcome the emotions of trading, then you know you’re ready to occasionally risk more than 1% of your portfolio. The second factor of trading is in the charting, and the strategy that you use on the charts. Once you gain a strategy that works 50% of the time or better, then you can contemplate if it is worth it to risk more than the normal amount.
Now that we understand risk management, risk-to-reward is the next thing to consider, and the topic of the next article.
Takeaways
In this article we looked at risk management and how useful and powerful it is. We also looked at the importance of understanding percentages and compounding.
- What it really means to risk a percentage of your portfolio.
- The basic 1% rule for starting out in trading, comparing numbers going down versus going up 1% every day.
- When you can risk more than 1%, using the principles of emotional management and strategic charting.
