Traders and investors, beginning and experienced, all need risk management. Without risk management, you are just gambling. Risk management makes you a better trader and more profitable.
In 2008 and 2009, brilliant minds met reality. Storied companies from Lehman Brothers to Behr Sterns vanished from existence. Dozens of banks absorbed smaller, bankrupt entities. Harvard MBAs, Stanford mathematicians, Princeton economists left these employers with boxes in their hands.
All of them failed at the foundation of investing – risk management.
Why Is Risk Management Important?
Imagine someone comes to you with an offer. Flip a coin 10 times in a row. If you get heads all 10 times, they will take everything you own. Otherwise, you get $1,000,000. Flipping a coin gives you a 50/50 chance of heads. Flip a coin 10 times, and your chances of heads every time drops to 0.10%. So, do you take the offer?
Managing risk not only smooths your profits, but it also keeps you from bankruptcy. With the offer above, you have a 0.10% Risk of Ruin. That means you have a 0.10% chance you lose everything. If you take the offer above enough times, you will eventually get heads 10x in a row.
Traders look at their Risk of Ruin as a point of no return. Once you cross that threshold, you’re done. Look no further than Lehman Brothers, or the infamous MF Global. Both companies took outsized risks for years. They played the odds that their winning trades would continue. Yet, they did it enough times that it eventually failed. When they failed, they lost more than they could afford.
Risk Management for Traders
Traders who open a new account tend to start with small amounts of money. Risk management becomes crucial to growing the account without emptying it. Without risk management, small accounts quickly deteriorate below margin levels or minimum account balances.
Let’s look at an example.
Account: You start with $2,000 in an account. The account cannot fall below a $500 minimum balance.
Option 1: Every time you trade, you win 90% of the time. Each trade pays $15 for a win, but each loss is $100.
Option 2: Every time you trade, you win 50% of the time. Each trade pays $800, but each loss is $500.
The expected payout for each is:
Option 1: (90% x $15) – (10% x $100) = $3.5
Option 2: (50% x $800) – (50% x $500) = $150
Seems like a no-brainer. The second option pays out way more each time. But what are the chances of me falling below $500 in each case? In both cases, you would need to lose $1,500 without winning once from the start.
Option 1: ($1,500 / $100) = 15x, which means your odds are 10%^15 = basically non-existent
Option 2: ($1,500 / $500) = 3x, which means your odds are 50%^3 = 12.5%
Are you willing to take a 1 in 8 chance that you would bankrupt yourself? What hurts here isn’t the actual odds of each trade. It’s the number of chances you get. Everyone wants to play pocket Aces in poker. But, would you bet your house, knowing there’s a slim chance you could be homeless?
Methods of Risk Management
Traders and investors need prudent risk management. The same strategies for risk management work for both. Most strategies involve not just the management of capital, but the types of trades and investments.
Diversification – Not only can you hold unrelated positions; you can trade that way. Trading or investing in one company opens you to company-specific risk. Playing in one sector opens you up to sector risk. By trading and investing in unrelated markets and companies, you lower the chance of all going bad at once. You can even trade some stocks long and others short to diversify away your market bias risk.
Percent of Total Capital – You can allocate a certain percent of your total money to a position. How much you allocate depends on your risk tolerance and probabilities. Traders often use the 1% rule to manage risk.
Staircase – Staircases increase or decrease the amount per trade at standard thresholds. For example, you can risk $50 more/less at each $1,000 increments in your portfolio.
Stop Loss – A good stop loss will let your trade play out but keep you from losing everything. You define where you will cut your losses. This can be used for an individual trade, a given day, or any number of combinations.
Profit Target – Knowing your profit target lets you define the potential reward. This lets you see how much you could win vs. how much you plan to risk. Couple this with a probability of a win, and you can see your expected return.
Evaluating Risk Management Strategies
No one measure will tell you everything about your strategy. You need to consider multiple measurements to evaluate your performance. Here are some common ways to assess your strategy.
Drawdown – The total money you’re down at any point during trades. Average and maximum drawdowns show you how much your trade dips before recovering or failing.
Win Rate – Your percentage of trades that become winners. You divide the total winning trades into the total number of trades.
Profit Factor – The total amount you won and divides it by the amount you lost (both are positive values). Anything over one and you’re making money. Under one and you’re losing money.
Total Profit – How much you made at the end of the day. Nothing more, nothing less.
Profit Per Trade – The average amount you make per trade. If you’re unprofitable, this will be negative.
Sharpe Ratio – The Sharpe Ratio compares your returns to the risk you take. You compare the returns you make to some benchmark, usually the risk-free-rate. The lower the Sharpe ratio, the less you’re making for your risk.
Common Sense Above All Else
I cannot stress enough the importance of common sense. When you look at something that looks to good to be true, it probably is. Trade strategies need to align with what you can handle. Strategies that join big risks and big rewards aren’t ideal for your 401k.
Just because a strategy looks like a winner doesn’t mean it’s right for you. You will find plenty of millionaire traders on the internet. Go back to the ’90s and you’d find even more. Statistics say that someone will get lucky. For the rest and the best of us, we rely on disciplined risk management.