Effective Risk Management Strategies for Traders

So it’s not about how much money you make as a trader, but it’s about how much money you actually keep. In order to keep a lot of money, you need to learn how to protect your capital. This is where risk management kicks in. Risk management, in my opinion, is one of the key pillars of successful trading. You have to have everything down packed with risk management. You need to have the proper strategies and formulas to know how much money you should be losing per trade and what is your maximum drawdown.

Most traders that don’t have the risk management strategy down packed and don’t follow it typically tend to blow their accounts very quickly in a short period of time. In this blog post, I’m going to break down a risk management strategy that everyone should implement as traders if they really, really want to protect their capital and stay alive in this game for the long run.

Understanding Risk in Trading

When most traders are starting out, they don’t know how much money they should risk per trade based on their account size. What typically happens is someone opens up a brokerage account, funds their account, and just takes massive trades, massive strings, and massive positions. It only takes one or two bad trades to wipe them out.

As a trader, you want to keep your capital protected at all times. You have to understand certain fundamental truths about trading. The first truth, which is the most important one, is that you are going to lose money. There’s no way around it; it’s impossible for you not to lose money. It’s going to happen. But the idea is for you to limit how much you lose. That’s what has to be applied in each and every single trading component: how much money are you going to lose, meaning limiting your downside. That’s where risk management kicks in.

Implementing the Two Percent Rule

I’m going to give you guys a few examples that everyone, I think, should implement. Let’s say you’re starting out with a two thousand dollar account. You have two thousand dollars invested into an account. What a lot of people do is they take this $2000 and dump it in one trade. They go in one trade and put all the money in that one trade. This, in my opinion, is not the right way to go about it because you are risking your full capital and you don’t know any logistics of what’s going on.

Based on your account size, you want to know how much should you risk for each trade. A typical rule is the two percent rule. When you follow the two percent rule, you have to make sure that you’re only willing to lose or put up a risk of two percent of your account size. What that means is if your account is at two thousand and you’re risking two percent, you should only lose a maximum of forty dollars per trade. For example, if you have a two thousand dollar account and you’re risking two percent, the most you should lose on a single trade is forty dollars.

I don’t think you should increase this, especially starting out. I think even starting out, you can reduce this to maybe one percent. I don’t think you should go higher than two percent, and that’s like the rule of thumb that a lot of traders really, really follow. I understand looking at this, it’s not exciting. But you want to understand, especially when you’re starting out, you want to limit your downside. By doing so, you want to have a maximum loss per trade.

Calculating Position Sizing

This is how you use the formula of the two percent. Let’s keep all these facts up here and understand. Once again, you have a two thousand dollar account. I’m going to put it up right there. Max loss is two percent, which is forty dollars per trade. Let’s say we’re looking at a stock that is trading at $10. This is where position sizing kicks in. We know how much we should lose on a trade on a maximum amount. But now the second aspect is, how many shares do we buy? That’s going to be adjusted based on each and every single trade you guys take. Every trade is going to be different.

Let’s look at Trade A. Let’s say a stock is trading at $10. Obviously, before you guys take any position, I highly recommend that the first main thing that should be outlined right off the bat is knowing where you will exit, knowing where you are going to be wrong, and knowing where you are going to cut your losses. That has to be established right off the bat. If you get into a trade and you don’t have that established, don’t take the trade. That’s the worst thing to do. Don’t set that area after you get into the trade. No, set that in the trade before you execute the trade.

Setting Stop-Loss Orders

So $10 is where the stock is currently trading at. Now, before you take this trade, you have to say, “What area should I set a stop loss at? What area should I exit at?” This area has to make sense based on price action. You can’t just look at a random stock chart and say, “I’m going to put a stop loss at $9, $8, $9.20.” No, that area has to make sense based on real price action. What is the chart telling me?

In this situation, let’s say $9 is a key area for this stock. Key area meaning every time the stock went to $9, it bounced up. Obviously, this is very elementary stuff, and I’m trying to focus on it from a basic aspect. But let’s say we’re looking at the $9 mark. The $9 mark has a lot of support, so we are going to put our stop loss hypothetically at, let’s say, $8.90. Actually, just for math purposes, I’ll make another video on how to properly place your stops. But let’s just say we put our stop loss at $9, and I’ll go over a whole new video on ways to place stops. Placing stops is a whole new topic and training that you must master: knowing when to take a loss and knowing when to exit.

Let’s just say in this area, we are going to exit if this stock gets to $9. The reason we select $9 is because $9 makes a lot of sense based on price action. We are risking $1 in this trade. The formula or the math that we have to do behind this is to understand that the maximum amount of money I can use on this trade is $40 based on my account size. On this trade, I’m losing $1 per share. So all I typically do is divide the share price, meaning how much I’m losing per trade, by my total trade amount. For example, it would be me dividing the dollar by my $40 per share, which allows me to buy 40 shares of this stock.

Why? Because if I buy 40 shares at $10, in this situation, what I can basically do is if I have 40 shares right here and this trade goes against me, which it can obviously, and like I said before, every time we take a trade, we want to make sure we implement the basics. If this trade goes against me, I lose $1 per trade. But because I have 40 shares, I am only losing $40, and that was my max loss per trade. If I have 100 shares and it goes to my stop-loss area of $9, I’m now losing $100, which is way over my two percent rule.

Example of a Different Stock

Let’s work with a different example just so we can understand a little bit better. Let’s say a stock is trading at $10, and we have a stop loss at $9.50, meaning we’re losing 50 cents per trade if we are wrong. In this situation, same thing: 50 cents divided by 40, we now get 80. Now we can buy 80 shares, and if we are wrong, we lose $40. This is what you have to keep in mind: don’t place your stop loss in the area based on risk management because of how many shares you want to buy. Don’t look at this chart and say, “You know what, I’m going to put my stop loss at $9.50 because I want to buy more shares.” No, place your stop-loss in an area where if the stock goes there, you will be wrong.

Once again, I have a video on where to place your stops, which I’ll break down. But you really need to know how to place stops the right way because this will save you a lot of money and a lot of bad mistakes. So that’s the first whole component of risk management.

Recap and Final Thoughts

Let’s recap that real quick. Have a two percent rule based on your account size: what is the max amount I’m going to lose on my account? The second thing I want you to do every time you take on a position is understand how many shares can I buy based on where I’m going to exit. If I am wrong, I am around this area. What I want you guys to do is comment down below what your two percent rule is. If your account is at a thousand dollars, that puts you at a two percent loss of twenty dollars. If your account is at two thousand dollars, that puts you at forty dollars. I want you to comment that right now so everyone is on the same page and understands what their max loss should be.

I understand when you look at this, it sounds very boring because it’s like, “Okay, Omar, I’m risking $40 on a trade. If I’m risking $40 on a trade, what am I possibly making? I’m risking $40; I’m possibly making $80, maybe $120, because it’s a three to one or a two to one ratio.” But you have to understand the longevity of this game. The longevity of this game is you always want to protect your downside. If you’re not protecting your downside, what’s going to happen is you’re going to end up having major drawdown, meaning your account equity will go like that in one trade. If you take a major hit on one trade, that is the worst thing you can do for yourself as a trader. Keep this in mind moving forward.

One of the holy grail things of trading, besides looking at indicators or price action or understanding any of that, is to protect and preserve your capital. You need to learn how to do that and implement it if you really are serious about trading for the long run and making this an actual career. If you guys have any questions, please follow my Instagram. I’m going to post my Instagram right here. DM me; I’ll be answering any trading-related questions at all there. Once again, if you liked the video, please give it a thumbs up and subscribe to this channel. I’ll see you next time. Thank you.

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