Every winning trading strategy has one thing in common.
They all use strong risk management.
In order to manage risk well, it’s important to establish rules.
You need to create these rules before you put real money on the line.
They should cover things like:
- Choosing position sizing.
- Maximizing the risk-to-reward tradeoff.
- Managing winners and losers.
By creating and following rules, you can greatly improve your odds of success.
Mathematicians, investors and traders are always searching for the optimal position sizing for a strategy.
Often, traders determine the appropriate position sizing by using formulas.
These formulas calculate an ideal position size based on things like the probability of winning or losing and the average gain vs. average loss.
If position sizing is too large, traders can get wiped out after a few losing trades.
If sizing is too small, they may not make any money.
Maximizing Risk to Reward
Before putting a trade on, traders must understand its reward-and-risk potential.
Sometimes these figures are clearly defined, and other times you must estimate them.
For example, an option trade may have a known max gain and max loss at the beginning of the trade.
But a stock’s reward-to-risk ratio may not be as obvious. In this case, traders estimate it using charts and models.
Regardless of the trade, the general idea is the same.
The goal is to choose a trade with high reward potential in relation to risk potential.
Some traders and investors will only take a trade if the reward-to-risk ratio exceeds a certain number.
Managing Winners and Losers
Managing trades and investments can be harder than choosing them to begin with.
This is because deciding how to manage a trade can be an emotional decision for many people.
When trades go south, it can be human nature to hold onto them.
For some, taking a loss feels like admitting to being wrong. Most people don’t like to admit they were wrong.
When trades go the right way, it can be tempting to take profits early.
Taking gains off the table feels good. And some fear that the open profits will evaporate quickly.
But holding losers too long and cutting winners short can derail a strategy even if the majority of the trades are winners.
Some traders will set hard rules that determine exactly when they should sell losers and winners.
Check Out Ian King’s Newest Trading Strategy
Creating and following rules can improve your risk management process and overall trading strategy.
Without risk management, even the most brilliant minds in the world will fail.
You can learn a lot about risk management from my colleague Ian King.
Risk management is the backbone of his newest strategy that he will be sharing with the public soon.
Research Analyst, Strategic Fortunes
The stock market is closed today in observance of Martin Luther King Jr. Day.