Risk Management
Table of Contents
Introduction
“I’m always thinking about losing money as opposed to making money. Don’t focus on making money, focus on protecting what you have.” -Paul Tudor Jones
“You should take the approach that you’re wrong. Your goal is to be less wrong.”
Check out this interview from Elon Musk: https://www.youtube.com/watch?v=0Bo-RA0sGLU
When we refer to trading, humility is extremely important. One of the first traders I learned from, Gerald Peters, always said women are better traders than men because they lack the ego and stubbornness of men.
Men overcomplicate things and, typically, think we are always right. All the time.
This was the biggest hurdle I had to overcome and ultimately cost me more than $75,000 in trading losses. That doesn’t even count opportunity cost. Likely more than $250,000.
When I took a trade, I always took the approach of being right, obviously, or I wouldn’t have taken the trade in the first place. I’d also size as if I will be right. Double no-no.
When a trade wouldn’t work right away, I’d move my stop loss or average down. Eventually getting to the point where the trend has been lost and you can’t cut now because there has to be a bounce soon.
After the loss, it was never my fault. It was the right idea so it didn’t matter. Or I was just a day too early.
Regardless, I oversized and lost 80% of a trade.
When you take a trade, assume you are wrong. Plan to be wrong. Stick to your stop loss.
Try to be wrong less often, but assume you are wrong.
Focus on how much you can lose, not how much you can make.
Suits, Season 2 Episode 6 - All In
Keith, founder & CEO, has a gambling and alcohol addiction. He has been clean for 5 years, however, finds himself in a private room poker game. Keith has a perfect hand and goes all in with one card left to flip. He borrows money from a nearby spectator totaling $3,125,000. Keith’s hand is Ace-King Full House, 4th best hand in poker behind Royal Flush, Straight Flush, and 4-of-a-Kind.
Harvey, Keith’s Lawyer: This is a bad idea.
Keith: You haven’t seen my hand.
Opponent: I call. Straight.
Keith: Full House.
Keith has him beat. Unless the river is a 10 of clubs which would give his opponent a straight flush.
10 of clubs. Tough Luck. -$3.125,000
Keith: Harvey it’s worse than it looks; I just lost my company.
Keith had put his company up for collateral on a cocktail napkin.
Harvey: Explain to me how you sell your company on a cocktail napkin at a poker table.
Keith: I had aces full of kings.
Spectator: Well, the odds were with him.
Keith: Yeah, come on. You saw it. It was bullshit. The guy rivered me.
Harvey: No. What’s bullshit is you should have never been at that table in the first place, much less drunk at that table. What exactly was on the napkin?
Keith: The deal was he was gonna give me 3 million dollars to back my bet. And when I won, I’d give him his money back with an extra half million.
Harvey: And if you lost, he’d just get the company.
Keith: Sighs. I didn’t think I could lose.
Do you see the issue? Keith assumed he had already won. So, there was no risk going all-in and betting his company. But there’s no guarantees in gambling or trading no matter how great the odds. I’ve had A+ trade ideas with 90% success rate fail. I analyze to see what I missed, but I didn’t miss anything. It just didn’t work that time.
Harvey was right, Keith should’ve never put himself in that situation at that table because he has an addiction. As traders, we should never put our account at risk no matter how great the idea may be. You never know what will happen or what news will strike. Your account could be gone in an instant.
The Holy Grail
Risk management is The Holy Grail of trading. I’ve spent thousands of hours learning patterns, strategies, and indicators. Looking for the best solution to trading. I studied my best trades. How to time entries on 1D dips using smaller time frames. How to trade reversals. How to buy consolidations. How to buy breakouts. How to buy pullbacks. How to short rips.
There is no winner take all strategy. But here’s the secret:
You could win 85% of your trades but if you don’t have clear risk management, you’ll lose it all on 15% of your trades. I know because I’ve been there a hundred times.
Risk management takes discipline and humility to admit that you were wrong and to do it quickly.
How to Win Big & Lose Small
Here’s Your $1,000,000 Position Size Formula:
Position Size = Account Size * Account Risk (%) / Stop Loss (%)
The only rule is that you never risk more than 5% of your account.
For example:
Account Size = $5,000
Account Risk = 5%
Stop Loss = 20%
Position Size = $5,000 * 5% / 20% = $1,250
Your position is 1/4 of your account which is large and will allow you to grow quickly. This is a low risk plan in reality. But you have to stick to your stop loss no matter what or you’ll lose 1/4 of your account.
Long Term Approach
Listen as traders & investors, you are in the industry that has created more wealth than any industry in the world. It is not the wrong decision.
These skills, traits, and beliefs all compound. THAT is what yields crazy outsized returns….seemingly overnight. Everything compounds.
You must treat trading as a business, an extremely scalable business.
Trading is not:
- Entertainment
- Thrilling
- Video game
- Exciting
- FUN
- A hobby
Trading is:
- Your job
- Your business
- Your livelihood
- Your freedom
If you treat trading as a hobby, gambling, or your adrenaline, thrill seeking excitement, you will not last long. I promise.
Go surfing, snowboarding, or water skiing for your thrill & adrenaline rushes.
If you were starting an athletic apparel brand, you would be looking to build small wins over the course of years. Small businesses don’t make it overnight. Neither will your trading business.
Focus & get your mind right, because you will make it. If you take it seriously.
Trading is a long game and it has the ability to change your life forever. If you understand the risks and can stay emotionally level. Traders fail because they try to hit home run after homerun, over risking to hit it big and quit their jobs as soon as possible.
That is not the way.
If you can master trading, it is the most scalable business you can start.
When you zoom out, you can see that it does not take much to make a good living.
The average American salary is ~$52,000. To replace a $52,000 salary with trading, you’d have to average $206 per day.
$206 per day can be done regularly with an account as small as $1,000.
Take a look at what it would take to hit some yearly trading profit goals:
$200 / day = $50,600
$500 / day = $126,500
$1,000 / day = $253,000
$2,000 / day = $506,000
Slow down, take a deep breath, and zoom out. You don’t need to 3x your $1,000 trading account each day. Focus on good risk management and building upon what you have instead of losing it.
If you averaged $500 profit per day for a full year then your account would be worth $126,500. With a $126,500 account, your average trade size could be $30,000 while only risking 5% of your account per trade.
Trading is insanely scalable.
Reward:Risk
A proper risk management strategy will have a reward:risk ratio of at least 1.5:1. For every $100 you risk, you make $150. The higher your R:R, the lower your win % needs to be to breakeven. If your R:R is 2:1, you need a 33.33% win rate to breakeven. Not very difficult. See the table below
Tying It Together
The above all sounds great, but it’s not really realistic. No one is going to make $500 every trading day and come away with $125k. The fact of the matter is you will make mistakes and you will have losing days.
The table below represents a more reasonable approach accounting for trades per day, win %, and R:R.
Conclusion
In conclusion, risk management is The Holy Grail of trading. Every strategy will have losers and winners. Only you can keep your losers small by sticking to a reasonable stop loss.
Risk management, discipline, and an inability to control emotions is the #1 reason traders fail and is what this bootcamp is built around.
Implementing a trading strategy is the easy part. The hard part is managing trades going your way and becomes even harder when a trade goes against.
Make it easy and stick to your stop loss no matter what.
There will always be a next time if you stick to your stop loss, but there will not be a next time if you go to zero. Remember, the market isn’t going anywhere.
Not sticking to my stop loss has hurt much worse than a 20% win has felt good. Please, stick to your stop loss at all costs.
Bonus: Custom Order Types, Stop Losses, and Trailing Stops
Thinkorswim offers the ability to place custom orders. I have set up this custom buy order for example to automatically implement a 30% target and 15% stop loss as soon as my order goes through. This represents a 2:1 R:R.
Stop losses are a great way to manage risk. When you set a stop loss on an option contract it may be difficult to know where the stop is on the underlying. Thinkorswim adds an expected price as you change the premium stop loss price so you know an approximate location of stop loss on the underlying.
To allow your winners to win big, instead of setting orders at your targets keep raising your stop as price moves in your direction. I’ve personally hit some major winners with this method.
When using market stop losses, ensure your contracts have high liquidity and small spreads or your stop will get filled at a much lower price than what you set. This is a major reason we recommend the stocks to trade later on.
Another order type you can use is a trailing stop loss. I will use this type of order on parabolic runners. If you set your trailing stop to 0.20, then the stop will automatically move to -0.20 of the highest price. If you set a trailing stop of 0.20 when the premium is equal to 3.0 and the premium moves straight up to 4.0 your stop will now be at 3.8. Therefore, your contract will only get sold when the premium price dips 0.20.
