It is easy to become enamored with your trade entry strategy, and its ability to show how many times the price moves in your favor. Many strategies are geared towards catching momentum or following a trend. To successfully prove that a trading strategy will work over time, you need to formulate a good risk management strategy. Even before you risk your first dollar, you need to have a keen understanding of how much money you plan to risk.
What is Risk Management
Risk management is a multi-level concept that starts at determining how much money you plan to risk on your investment strategy. The goal should be to make money consistently and to have a realistic concept of how risk works.
It’s important to understand that your reward will be predicated on the risk you take. If you are unwilling to take any risk, then your return will be what is called the risk free rate of return. Most consider the risk free rate as sovereign government debt, such as the US treasury bill. If you lend money to the US government for 1-3 months, you are guaranteed to make money, but the return will be lower than if you take additional risk.
You also should only risk money that you can afford to lose. The younger you are, the more time you have to make back your money if you lose it. If you are only risking discretionary money that you do not plan to use to buy food and shelter, then you need to determine what kind of return you want and that will help you calculate risk.
Once you determine the reward you want, you can calculate your risk. For example, if you are looking to make 30% for a year, with your online trading, you might consider losing as much as 10%. A 3 to 1 strategy is considered prudent. You then need to see if you can construct a trading strategy with this type of reward to risk ratio.
For example, if you want to use a trend following strategy, either you need to win 3 times for every 1 time you lose risking the same amount of capital, or you can win on successful trades more than you lose on unsuccessful trades.
If you make 9-trades in a year and you win 3 and lose 6, you need to make $6 on every winning trade for every $1 you risk having a 3 to 1 ratio (3 * $6 = $18 versus 6 * $1 = $6). Prior to testing your strategy, you want to make sure that you know how much you need to make to reach your financial goals and conform to your risk management. If you have a strategy that wins more than it loses, you can alter how much you plan to risk on each trade to generate the same 3 to 1 reward to risk ratio.