Why Most Traders Don’t Follow Their Risk Management Rules

Trading is not just about finding good entries and good exits, the best methodology is not worth a cent if you don’t know when to accelerate and how to use the breaks just like when driving a Maserati if you don’t accelerate this powerful machine wisely and know how to use the breaks, you will crash and burn.

You see, after working with hundreds of traders and reviewing their trading performance it is apparent to me that when traders talk about lack of discipline what they are really talking about is their inability to apply prudent risk and money management rules. That’s why in our next live trading night on Friday August 30 we will delve further into this topic and go through the practical application of money and risk management parameters, and how to easily calculate the correct position sizing.  

Certainly in my experience of trading and coaching this is one of the severe gaps that traders face: the theory seems simple and straight forward but the practical application is far more complex.

Risk Management really needs to address two potential sources of risk: Market risk, meaning that price is not behaving as expected and the risk of self, meaning that you as a trader don’t behave as required, i.e. not being disciplined in taking losses quick enough or taking profits too early. In my opinion the lack of discipline is due to irrational thought processes of 'not wanting to lose money', the Nick Leeson effect as I like to call it, meaning that we don’t want our spouse to know that we ‘stuffed up’ and also we want to be successful and have a better life enriched with freedom and choice and this dream seems to be threatened when taking a loss. All these unproductive thought processes are taking place in the part of the brain called the ventral striatum (as explained in last month’s newsletter).

Many traders consequently believe that they have emotional or trading psychology related challenges with their trading when in reality they just don’t have proper risk and money management strategies in place that are suited to their trading style and size of trading bank. This is what I call the ‘competence gap’.

The solution to move the thinking processes from the ventral striatum to the origin of logical thinking, the frontal cortex. This can be achieved simply by turning the focus back on the processes and numbers of your risk and money management strategies.

To give you an example, the traders of my high performance group have to fill in a business trading plan. Without fail every trader so far has used a 1 – 2% risk rule. But when I review their trading performance over the weekend, at the beginning 98% of traders let their losses run beyond the 2% with the exception of a few, and guess what, they are the ones who are consistently profitable.

When I ask for the reasons why the don't follow their own rules as per their trading business plan, the common excuses are:

-      I use a technical stop loss and that’s why I can’t keep the risk %.

-      My account is too small, so if I only use 1 – 2 % I couldn’t trade

-      If I only use 1-2% risk then I will never make enough profits to live of it.

-      I wanted to take my loss but it looked like it would turn around any minute so I was hoping to get out at a better price

-      Price had a massive spike (mostly my gold traders suffer from that!) and that’s why the loss is bigger than anticipated.

The response I give in such cases is: “So, if 1 – 2 % is not working for your trading system, account size, market of choice, why do you put it into your business plan in the first place?” and interestingly enough the reason is because they have read somewhere that this is what risk management is supposed to be so they adapt it without even investigating if it is suitable for their own style of trading.

It seems that most traders actually don’t have clarity around what those numbers mean.

There are several ways on how to calculate how much money to risk per trade. One is a fixed percentage of the original account size. To illustrate I used a $1000 trading bank, so it is easy for you to mulitply this figure to your trading bank accordingly: 

 

Risk % Risk $ Max Number of Losses Account Balance
10 100 10 900
5 50 20 950
2.5 25 40 975
2 20 50 980
1.5 15 66 985
1       10 100 990

 

This illustrates perfectly that it is still possible to eliminate a trading account simply by using the wrong ‘Trade Size’ (or position size), and how crucial it is to always focus on capital preservation to ensure a future in trading.

Another way is to calculate a variable percentage of the total account size at any point in time which is also called ‘capital adjusted risk’.

No of losses for 10% risk  capital adjusted Risk in $     Account Balance in $
1 100 900
2 90 810
3 80 730
4 70 640
5 60 580
6 50 530
7 50 480
8 40 440
9 40 400
10 40 360
11 30 330
12 30 300
13 30 270
14 20 250
15 20 230
16 20 210
17 20 190
18 10 180
19 10 170
20 10 160

Now that we know how much money it would be prudent to risk, let’s have a look at the concept of risk reward ration.

The RR ratio is calculated simply by dividing the expected profit (=reward) by the amount of money you believe is prudent to lose according to your calculations based on the tables above (= risk).

Reward / Risk = Reward to Risk Ratio

$200 / $100 = 2:1

$300 / $100 = 3:1

The reason why the Risk and Money Management can be confusing is because the calculations vary depending on your strategy, if you are a scalper, a swing trader or hold positions longer term, the market volatility, the time frame you are trading, the size of your trading bank, the size of your average win, the size of your average loss, your win loss ratio etc. So for example, if you have a lower win loss ratio, such as 60/40 then your Reward to Risk ratio must of course be higher in order to make up for the quantity of losses.

So, you can see there is a lot to consider when it comes to risk and money management.

I hope that was interesting and useful for you too and maybe I see you on Friday for the Live Trading Night.

With a toast to your trading profits

 

Mandi Pour Rafsendjani