What is Risk Management ?
Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities. Risks can come from different ways uncertainty in financial markets, threats from project failures, legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attack from an adversary, or events of uncertain or unpredictable root-cause. There are two types of events negative events can be classified as risks while positive events are classified as opportunities. Several risk management standards have been developed including the Project Management Institute, the National Institute of Standards and Technology, actuarial societies, and ISO standards. Methods, definitions and goals vary widely according to whether the risk management method is in the context of project management, security, engineering, industrial processes, financial portfolios, actuarial assessments, or public health and safety. Everything that we do involves some level of risks.
Many people use risk management when making decisions. Your health insurance agent takes your reading and assigns a risk to determine how much your insurance will cost. Homeowners insurance can be higher cost for someone living in a rural area than it is for someone living in town. The reason is because in the rural are there are no full time fire departments and it is higher risk. Even in our personal lives we calculate risk. Most people don’t want to be in the bad part of town after a certain time of night.
Just as we use risk management in our own lives we need to use risk management in trading.
How do we use Risk Management in Trading?
Risk management in trading has two parts. How much money will I put on the trade? How much will I lose?
We wrote about the formula before in the volatility podcast. We calculate how much to buy based on volatility. For risk it’s not something that we calculate it is something that is set. It is a little over 1% of the account value. In our studies we find that if you get over 2% it starts getting very risky.
The higher you go on the risk the higher your potential is to profit or to lose. Risk is very important.
How important is risk management?
Risk management is very important if not the most important factor in your trading system. You can’t be a trader if you have no money.
I have heard stories of when they built some of these famous bridges. The stories tell that the people were scared to death to do the work. This was before the safety devices that we have in today’s time. So many workers fell to their death.
Can you imagine trying to work knowing that one small move could lead to your demise? It would be hard to concentrate on the task at hand. How much would they have to pay you to get out there and work knowing that you could die? For most the risk would not be worth the reward.
In trading it is the same. How much are you willing to lose before the risk is not worth the reward?
You need to test the risk for yourself. For us is 2% max.
Cost of Poor Risk Management
The cost of poor risk management is an empty account.
Let’s look at an example. Let’s say are willing to lose 10% on one trade. In trading all trades are not profitable. All trades don’t end up with 20% gains.
If you make 3 losing trades then $100,000 would be worth $72,000 after 3 trades.
That is not very good. If the number is 5% then after 3 losing trades you would have $85,000. That is better but still too risky. If you are a new trader you need to understand that at some point you will lose three trades in a row.
What does 2% look like? $94,119
That is much better. For us 2% is still a little high we use 1%.
Higher than 2% makes is hard to recover from a string of losses.
Why can’t we wait?
The reason many people start out risking too much is their lack of patience. Patience is a virtue. Risking to much is a sign that you might see trading as a get rich quick scheme.
Trading is not a get rich quick scheme. It takes hard work and it takes time to get rich.
First you have to learn how to trade. Then you have to have the patience to stick it out.If your system has been tested then you have to believe in your system. You have to follow your system.