Understanding Risk for More Profitable Trades
Introduction
One of the greatest topics that plagues traders and sets the dividing line between success and failure in trading is the art of risk management.
Risk is defined by Webster’s Dictionary as the “forecasting and evaluation of financial risks together with the identification of procedures to avoid or minimize their impact.” Proper risk management is identifying those risks and appropriately handling them to minimize their impact on your portfolio.
Some say that trading is a gamble and risk management is a hoax because the outcome is always uncertain. This is true only to an extent. Gambling is defined by Webster’s dictionary as “to bet on an uncertain outcome”. By definition, trading is a form of gambling, however, by identifying risks, playing the odds, and employing careful management, traders can find a successful edge that will set them apart from someone pulling handles at a casino. Any professional gambler who goes to a casino can tell you that the odds of your winning are extremely poor. However, in trading, the only person you have to beat is yourself. If you can beat your emotion and win 51% of the time, you can be successful.
This article discusses the three main areas of risk management in a portfolio: trading style, position sizing, and loss limitation.
PLEASE NOTE: The application of this information applies to all portfolios from traditional investments to alternative investments. For the purpose of this article, I will be specifically addressing crypto currency investments. For the average investor, a crypto portfolio should not take up more than 15% of your personal portfolio due to its risk.
Trading Style
The first step to mastering risk management is creating a plan that suits your trading style.
There are many different types of traders. There are those that excel at picking up the quick 3% scalp executing this strategy 20 times and making 60% in a couple hours. Alternatively, there are those that excel at the long game, buying and holding for days to months on end and make 250% as a result of a single movement.
While a cross between the two styles is easy to master over a period of time, it takes a significant amount of practice as the two trades take very different mindsets. The largest failure in risk management for most traders is becoming confused trying to cross back and forth between the two. Traders will enter in a long trade, then freak out and try and scalp a small gain, then rage as the asset goes in their original trades favor so they panic and buy back in at a higher price. Alternately, traders will try a scalp and see the price going the wrong direction so they wait and let the assets ride claiming “it was a long hold” and lose the ability to continue their scalps by tying up capital. The lack of focus is a major failure and will haunt your entire trading life if left unaddressed.
The solution lies in creating a personalized set of principles for your own trading style. For many successful traders, the key to their early success was writing down every trade they make. As they realize which actions helped them create the best results they begin to follow those signals more and more. Over time, these actions became second nature and the writing was no longer necessary. This becomes their trading plan.
Let us cover different trading mindsets really quickly while we are discussing this.
Scalping: a scalper’s goal is to create micro transactions, repeatedly, hundreds of times, over and over again. This constant trading over a long period of time, if done properly, leads to small percentage wins that stack up enormously. These could be small 1–2% wins or 10–20 basis point wins. Scalpers have to be fast and agile, they watch the market like a hawk watching every single candle hoping for an entry point. These people are normally incredibly skilled, picking up technical analysis on patterns and trends faster. A large portion of scalpers are algorithmic bots trading back and forth on exchanges. Scalpers normally employ extremely tight stops, cutting off trades faster rather than risk cutting into capital.
This limits their downside and allows them to re-enter the market quickly.
Swing: these traders are in for the long game, they buy up dips and sit for days to months on end. They look for the big wins and if they play their hands right, can make the large figures seen see thrown around on social media. Often these traders rely on fundamental analysis and do not look too deeply into technical analysis, instead they wait for dips or reasonable entry points and stack up big positons. Holders normally have a lazy attitude to their risk, if they feel comfortable in their position, they will sit for days in a losing percentage confident in future growth.
Switching back and forth between these mindsets is never easy as one requires constant attention and the other requires a hands-off approach. However, after some practice it’ll become easier and you will quickly recognize what you are intending to trade as a scalper or swing trader.
Why does your trading style matter?
Understanding your personal style is what will reduce your risk. If you know what you like to do and take risks you are comfortable with, you are more likely to be successful. If you try to follow other trading styles, you may only get half the picture. You may know what other traders are investing in, but you may not know why, how much to invest or how long to hold. Once you are able to determine that for yourself, the extension of your risk follows along with it. Crafting your unique trading style takes time. Once you have a style that you feel comfortable with, you will understand which risk management style works better for you.
-> Continuation ->
Please Note:This article was originally published in full however, by popular request, this article has been split into a smaller series under the title of Art of Trading: Risk Management. To finish the series, I would recommend reading the second and third section of this topic Portfolio Position Sizing and Stop Losses and Final Thoughts.
If this has been of assistance to you, please consider a tip. Thank you for your consideration.
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Disclosure
The opinions and investment strategies of the author are their own and not to be construed as investment advice. With any type of investment, the potential exists to lose some or all of your investment. The author makes no guarantees of gain or increased profit and cannot be held responsible for losses incurred.
Cross Posted @ Medium.com.
Credit to Pexels.com for photos.
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