Trading: An Inside Look. Module 9: Risk Management.
1. Terminology
2. Introduction
3. Risk Scale
4. Stop-Loss or Loss Limitation
5. Hierarchy of Risk Management Elements
6. Leverage and Position Size
7. Long and Short Position Instrument
8. Moving the Stop-Loss Order to Breakeven
9. Position Scaling
10. Trading Account Management Models
11. Equity Curve or Capital Curve
12. Calculation of Exchange Commission
13. Calculation of RM for Spot Trading
14. Conclusions
1. Terminology
•Profit — profit.
• Risk management — the process of making and implementing management decisions aimed at reducing the likelihood of an adverse outcome and minimizing possible losses caused by its implementation. In trading, R is used to denote possible risk.
• Leverage — the use of borrowed brokerage capital to carry out margin trading.
• Discipline is the strict and precise observance of rules consciously adopted by a person.
• RR — risk to reward — the ratio of risk to reward (RR 1:5 will mean that I risk 1 to get 5).
• R is a conditional unit that a trader risks in a trade.
• WinRate is an indicator of a trader’s success, calculated as a percentage.
2. Introduction
Risk management is the most important part of trading, but also the most unpopular. This is a big topic, and today we will only cover the basic principles of risk management.
Professional and Intuitive Trading
The first thing a serious profit seeker needs to understand is that you should not chase quick results, otherwise it will cost you a tidy sum. You need to strive for the clear implementation of the rules that you set for yourself.
Trading is not a sprint, it’s a marathon. You need to focus on risk management and planned profit/loss taking. Everything must be precisely defined before the position is opened. The entry point, exit point and take profit point must be defined.
3. Risk Scale
1% — — 2%- — 5% — — — 10%- — — 50% — — — — 100% (Margin Call).
When we talk about systematic trading, we also mean adhering to a clear risk management (RM) system. RM systems may differ from each other depending on the tasks and experience of the trader. At the initial stage of building a trader career, we recommend not exceeding the threshold of 2% depossit .
The trader plans the loss. If the position is not closed at -1–2% loss from the total trading account, psychology comes into play. The next opportunity to close the trade will be approximately at -5% loss. If the trade is not closed at -5%, the next stop and key point is a loss of -10%. It is becoming increasingly difficult to admit a mistake.
The critical point where you must close a losing position is exactly -10%. Because after this zone, the next opportunity to close a losing trade will be approximately at -50% loss. After -50%, usually a person just looks at a losing trade and can no longer close the position. As a result, the trader receives a Margin Call — the exchange forcibly closes the position.
4. Stop Loss or Loss Limitation
The first thing to do when forming an idea about entering a trade is to ask yourself: where will the stop loss be located? Stop loss — literally — loss limitation. It is important to accept the fact that no one knows what will happen to the price next. After such a statement, a logical question would be: if no one knows and controls the market, then where are the levers of control in trading? The fact is that you need to manage not the market, but the one who observes the market — manage yourself. Both the rules and the trading system are made specifically for the trader, the area that we can learn to control. We can control losses. We do not control the price, but only observe the facts on the chart and assume the possible development of events, relying ONLY on the facts that are currently on the chart. Stop loss orders help us protect ourselves from losses if the trading idea does not work out.
If you commit to honoring stop losses at all times, you will be ahead of 99
The most common causes of losses:
1. Very large position size without a stop loss.
2. Very large position size with a very long stop loss that does not correspond to the correct RR.
3. Uncontrolled tendency to take risks, hoping to hit the jackpot, make a super trade.
4. A series of trades immediately after the stop loss is triggered (psychological pattern quot;Three Trades quot;, quot;Forced Spending Error quot;).
1. Technical (set beyond a certain level, an obstacle in the way of the price).
2. Percentage (stop is calculated as a percentage, percentage of loss relative to the trading account).
3. Monetary (stop is calculated in monetary terms relative to the trading account).
Depending on the type of trading system, one or another type of stop loss is used, we recommend using the percentage calculation method, where the deposit is equal to 100
IMPORTANT! When placing a stop loss order, keep in mind that the marking price is the average index of spot exchanges, so the possibility of quot;slippage quot; of the price is very high. The last price is the actual price of the asset, so this option is recommended when trading.
If my capital is 1000 and the risk per trade is 2%, this means that if my stop loss is triggered, then my losses will be limited to 20 (1000 × 0.02 = 20). In other words, I will lose exactly 20 (+% exchange commission).
The closer your stop loss is to your entry point, the larger the position size you can trade with the same risk. A tighter stop loss will give you a larger position size, but less room to maneuver. A wide stop loss will give a smaller position size, but more room to maneuver. In this case, only the trading volume changes, and the possible losses are fixed.
5. Hierarchy of Risk Management Elements
At the head of all calculations is the trading balance. It is from the deposit that the percentage of risk is calculated.
When we have decided on the amount of risk in relation to our trading account, we can find out what volume (quantity of goods) we can buy / sell.
When the position size is determined, the trader can choose the leverage that will be used for the transaction (buying or selling the trading volume). In other words, the trader determines how much of his personal capital will be used in the transaction. This does not change the risk, since the risk depends on the volume, not the leverage.
The commission is also calculated relative to the trading volume. The amount of leverage does not affect the amount of commission.
6. Leverage and Position Size (Qty)
Leverage allows you to not place all funds in your trading account and trade a larger position size.
Choosing a larger leverage only means that the trader wants to use less of their personal capital to open a position.
If a trader chooses a lower leverage, it only means that he wants to use more of his capital to open the same position. Choosing leverage will not affect your position size, leverage will only show how much of your capital you are using to open a position.
The exchange will NOT use your capital to keep the position open.
The broker can use all of your capital to avoid closing, but closing means that your total capital becomes 0.
This method is usually used by traders who work with several parallel positions. I do not recommend using cross margin if you are new to trading.
LEVERAGE DOES NOT AFFECT PROFIT. TRADING VOLUME AFFECTS PROFIT!
7. Long and Short Position Tool
To measure risk, we use the Long / Short Position tool on TradingView. The green area is the profitability area. Red is the risk area.
8. Moving the Stop Loss Order and the Breakeven Point
A traditional trade looks like this: we know the entry point and two exit points (stop loss as an exit at a loss, and take as an exit at a profit). When the trade is open, we do nothing and just wait for the price to reach the target. Either stop or take. This method is used in systems configured for small RR (for example, 3R). For systems operating with a larger RR, different trade management methods are used. One method is to move the stop loss order to get a breakeven point.
If the stop is moved early, the price may return, close the trade and go further in the right direction. Therefore, the stop is moved only after a specific event on the chart. After the price has updated the structure (confirm), you can place a stop loss below the level of the new low (or high for a short position). But it is important to remember that when the risk is reduced, the potential profit is also reduced, because even after a breakout, the price can return, close the position and go further in the right direction.
9. Position Scaling
Scaling is a position management tool.
There are two types of scaling:
1. Scaling up a position.
When a trading idea has already been formed, when opening a position, entry is made for a part of the volume, and not the entire planned volume.
For example, you have decided on an entry point and plan to open a trade for 1% of the deposit. Since no one ever knows what will happen in the market next, to reduce the risk, you can not enter the entire volume at once, but use only part of the volume and, with further confirmation of the idea, increase the volume to the desired value.
2. Scaling down a position.
Partial profit taking with positive trade development dynamics. There can be many methods, but they all have one goal — to fix part of the profit and reduce risk.
• Fixing 50% with RR 1:1 (breakeven without moving the stop loss order).
• Fixing 30% with RR 1:3 (risk reduction, partial profit taking).
• Fixing 25% with RR 1:4 (breakeven without moving the stop loss order).
10. Trading Account Management Models
Goals are also important when opening a position. The variety of trading approaches at the beginning of a trader’s journey is a natural phenomenon. But, one way or another, there comes a time when you need to decide on specific trading rules.
The classic problem of the trading process is the desire for a large RR. This desire is caused by the fact that a person wants to get everything and quickly, and it is very difficult for him to wait. Another problem is a small deposit, because even with proper trading, the profit will be compared to the usual monetary equivalents and will not bring joy.
First, let’s look at the WinRate calculation formula:
WinRate = (number of profitable trades / total number of trades) x 100
Table of the ratio of WinRate and the RR coefficient (Risk to Reward):
BE (break even) — Break-even level.
Loss — Loss-making trade.
Profit — Profitable trade.
So, let’s designate the working month as 20 days and consider the regular profit taking (about losses later) in the amount of 3R:
• If every day for 20 days a trade +3R = 3x20 = 60R is closed (if the conditional risk was 1% of the trading account balance, then 60R = +60%).
• If half of the trades within 20 days are closed +3R = 3x20 = 60R x Winrate 50% = 30R (if the conditional risk was 1% of the trading account balance, then 30R = +30%).
• If a third of the trades within 20 days are closed +3R = 3x20 = 60R x Winrate 30% = 18R (if the conditional risk was 1% of the trading account balance, then 18R = +18%).
Let’s look at an example in real numbers. If the deposit is 100, the risk is 11), 3R = 3, 15R = 15, etc. One can reasonably object: but I don’t want to get 15 from 100, I want to get 1000 from 100, etc. This is also possible in some cases. The reason for such ideas is a small initial deposit. But here’s what the risk-to-reward ratio looks like with a large deposit.
R = 1
3R/day = 300 ( 100x3 )
WinRate 100300x20 = $6,000
WinRate 50% = 300x20 = 6,000 x 50% = $3,000
WinRate 30% = 300x20 = 6,000 x 30% = 1,800
R = 1% = 2,000 US dollars
3R/day = 6,000 ( 2,000x3 )
WinRate 100% = 6,000x20 = 120,000
WinRate 50% = 6,000x20 = 120,000 x 50% = $60,000
WinRate 30% = 6,000x20 = 120,000 x 30% = $36,000
Imagine that the size of the trading account is 1,000, and the risk (R) is limited to 11,000 = 10.
The trader made 20 trades per month, 11 of which were profitable: (11 / 20 ) x 100 = 55
Accordingly, if out of 20 trades 11 were closed in plus, then 9 were closed in minus, which is equal to -9% = -9R = -90.
Total: +330 (profit from 11 profitable trades within 20 days) — 90 (total loss from 9 trades within 20 days) = + 240 net profit.
11. Equity Curve or Capital Curve
Simulation of the dynamics of a trading account with given values of the trading system. We use web resources for visualization.
12. Calculation of Exchange Commission
Since we use limit orders to open a position and market orders to close, the commission for opening and closing a trade will be different.
For the maker, that is, using a limit order, the commission on the Whitebit exchange is 0.01%, the taker is 0.035%. Thus, for one trade you will have to pay 0.01% + 0.035% = 0.045% of the trading volume.
Commission calculation formula:
Asset price x asset volume = volume in
Volume in x 0.045% = commission for 1 trade
For example, you are opening a position with a volume of 0.245 BTC. This value must be multiplied by the asset price, for example, 28700:
0.245 x 28,700 = 7,031.5 (we get the equivalent in USDT)
Next, we multiply the resulting value by the percentage of the commission:
7,031.5 x (0.045% x 100) = 7,031.5 x 0.00045 = 3.16
The commission will be 3.16 USDT. Thus, if the stop loss is triggered (if SL = 1
The larger the volume, the larger the commission.
Note: for the spot market, the commission is 0.1% (taker/maker).
The main idea of working in the spot market is portfolio decomposition and risk diversification. The primary task is to preserve capital, and only then increase capital.
Risk calculation for spot is carried out not using the “short/long position” tool, but by dividing the deposit into parts. Thus, risks are diversified.
For example, we have a deposit of 15,000 USDT. We recommend leaving 5,000 USDT in stablecoins (USDT) as a reserve, we use the rest for trading. We allocate 1/10 for the purchase of each asset, which is 1,000 USDT. We set the stop limit at 10% of the downward movement on the chart, since we trade in the medium and long term in the cryptocurrency market, where there is high volatility, and a stop at 3–5% of the movement on the chart will be triggered much more often.
Remember, anything can happen in the market at any time. If the stop is triggered, then 10% of the total position volume will be 100 USDT, which is 1% of the trading deposit and 0.67% of the total deposit (15,000 USDT). The risk is minimal, isn’t it? Depending on your choice of risk per trade and your money management, you can raise the risk up to 2–3%.
The main timeframes for spot trading are W D 4H, and 1H is used to refine the entry.
On the spot, you can only place an order to buy or only to sell. Use a Stop Limit Order, not a Limit Order. If you use a Limit Order to set a stop level (the selling price is below the asset price level), the trade will close at the moment and the asset will be sold at the market price. The price of a limit order should always be higher than the price of the asset. Therefore, we use a Stop Limit Order to work with stops. We also use a Stop Limit Order for takes.
You should not sit out in a big minus, which can reach 30% and 50% and 70% of your deposit. It is better to exit the trade, wait out the unstable situation in the market and buy the asset cheaper.
14. Conclusions
1. Do not buy or sell an asset until the price is at a specific point according to the TS.
2. Do not enter a trade if you do not know where the stop loss will be.
3. Do not try to bend the market to suit you by placing a stop loss where it is convenient for you. The market is not interested in your interest, and only you can take care of yourself.
4. Do not move the stop loss. This means only one thing — the deal was not properly thought out and the possible loss was not emotionally accepted before opening the position. This behavior will quickly lead to losses.
5. Do not place a stop loss at the level of liquidity accumulation.
6. Respect risks more than profit. Learn to fix losses ONLY within the framework of a well-thought-out trading system.
7. NEVER invest your last money. You can only invest free money — those that you do not need for life support in the near future.
8. Do not start your trading journey with large sums. Working with a minimum volume and small amounts of money will give you a clear understanding of how you make decisions, how you act, how disciplined you are, how ready you are to follow your rules. Invest money that you can afford to withdraw from your personal or family budget without fear of being stranded. Trading is not gambling, but a process that requires knowledge, skills and abilities. It is important to master the skill, test the trading system on a demo or a small real account, and only then, if there are positive statistics, gradually increase the deposit.
9. If you are concerned about the stop loss, reduce the volume until you feel comfortable.
10. Remember that you can lose money that you have systematically earned over days, months, or a longer period in seconds.