Trading is a risky affair, period. Just like how much faster you make money by trading, it’s fairly simple to lose everything at one shot as well. A lot of traders out there have expertise in the technicalities involved in algorithmic trading such as coding, quantitative aptitude, statistics, math, and more. But what they lack is one simple yet crucial virtue that will keep losses off shore. It’s called risk management.
For most quants, risk management ends up as the least priority in their quantitative trading checklist. They work on finding precise entry signals, identifying better indicators, or understanding and eliminating unethical trading practices. But the truth is, without getting to know about risk management and the psychology behind it, you cannot expect to become a successful trader.
More than the conventional definition that a search engine would pull out, risk management is like a discipline that you should stick to. It’s like slowing down before an approaching speed-breaker when driving a supercar at its best speed. Slowing down decreases the impact of the speed-breaker and ensures there’s no carry-forward of it. Blindly speeding ahead would only result in a crash, which you want to avoid.
In this article, we discuss some basic do’s and don’ts of risk management. We’re using “you” and “your algorithm” interchangeably, the same principles apply to both.
1. Plan your trade — Setup points of entry and exits
Point of entry is simply where you enter into a trade. Once in a trade, you will either exit with a profit or a loss — but know these in advance. In a well executed trade, you know when to enter a trade, the expected profit from the trade (i.e. when to exit with a profit) and when to exit your trade if things don’t go your way (stop-loss). And then you stick to these (unless ofcourse something changes drastically voiding your earlier assumptions). This not only brings order and discipline to your trading, it also prevents you from making biased decisions once you’ve entered into a trade. Don’t fall prey to the most basic trading folly — cutting your profits out of fear and letting your losses run in despair!
2. A big NO to one size fits all exit points
A lot of trading strategies will ask you to follow some shortcuts in trading — use fixed number (% change in price or points) as your exit point for profit orders or stop loss across diverse instruments. The fact you’ll overlook in this case is the basic common sense of how prices fluctuate in the market and how markets function. Markets are considered volatile for a reason — how prices move around and fluctuate changes daily. There using the same fixed number in different scenarios makes little sense.
When you see high volatility, widen your profit orders and stop loss so you can ensure profits even if the price swings are more. Similarly, during low volatility, set your profit orders and stops close to the points of entry.
3. No Break-even Stops please!
A dangerous strategy to deploy is to create a no-risk trade by setting your stop-loss as the point of entry. I will exit my trade with a small loss should things not go my way, right?
NO! This is an unprofitable venture. When your trading strategy is based on common trading parameters such as moving averages, chart patterns, support and resistance, and highs/lows, the point of entry you fix on is very similar to that of hundred other traders. This often leads to price retracing around the entry point levels before turning to its original direction. Setting your breakeven here will make you exit most of your trades too early, without realizing there full profit potential.
4. Dynamic Position Sizing
When you make a trade, you’re betting on odds of a favorable outcome, just like playing poker. In poker, it’s common practice to vary the amount you bet based on the likelihood of the outcome - if you hold a very strong hand, you’d bet more than when you see low chance of winning, right?
The same holds true for trading. Dynamically increase or decrease your position size based on the expected profit from a trade. Typically, start with a small position and slowly size up on the trade as it becomes more attractive. And don’t hesitate to hack or size down if things start going against you.
Following the approach of dynamic position sizing will help reduce your volatility and potentially help you improve overall profits.
5. Know when to Skip the Trade
One of the most effective risk management strategies is to know where to place your stop loss and take profit orders. Doing this will allow you to identify the average price ranges for the orders you’ve set and help you assess the reward:risk ratio. When you assess and discover that the ratio doesn’t fall in line with your requirements, skip the trade.
If you intend to increase your reward:risk ratio and widen profit orders, you’ll end up losing the hold on your trade. A lot of traders do this and fail in their trades. Don’t be one of them.
6. Discipline your Performance Targets
The very basic rule of risk management is to know when not to trade than knowing when to trade. A lot of traders simply trade everyday because they’ve set a daily performance target they would like to achieve. More than adding pressure, it simply increases the chances of loss.
Set the right trading goals and follow them. You can bring in discipline to your trading by setting weekly, monthly, or semiannual goals and work towards it. Plan the trades ahead, journal or write down your trades, review them, analyze them, focus on the gap between your plan and execution and come up with rectification strategies. This will eventually make your trading a profitable one in the coming days.
Risk management is more of a discipline that you should try and practice in your trade. Profitable trades are often ones that are well planned before execution — knowing the point of entry , profitable exit, stop loss, when to size up or down and sticking to these without getting biased with your emotions. You can become a master of all the technical aspects of becoming a trader, but if you don’t have a control over your emotions that drive the urge to trade, remember you’re in trouble.
Good luck!
