Mastering Risk Management: A Trader's Gauide to Long Term Success/ A beginner to Advanced level Trading cource Part#3

                                                                                 

                                                                        

 Risk Management                                                                                   

Risk in trading refers to the possibility of incurring financial losses due to

adverse market movements or unforeseen events. Financial markets are

influenced by a lot of factors, such as economic indicators, geopolitical

events, and market segments, which can lead to price fluctuations. These

fluctuations can result in significant gains or losses for traders. 90% of the

traders lose money due to a lack of risk management. Everything that we will

discuss in this tutorial will aim at possibly making you part of the remaining 10%

who doesn’t lose all their money?

 Invalidation:

As a trader, the market is the first and foremost authority that will rate your

performance.

Let’s discuss the most important piece of information in trading - to know

when you’re wrong or your trade invalidation point.

For example, concerning the image above, a good analogy for
invalidation would be a passenger on a bus. He wants to get some ice
cream, the bus goes through multiple paths and the path it will use
today is not clear. There is one stop with ice cream on each route as
discussed above. The moment he reaches the stop with ice cream, he
has to get off, regardless of which route it was, he can’t stay on the bus
and hope that the next day the bus will take him to the other shop.
Similarly, as a trader, you are supposed to exit the trade at either target
or your stop, regardless of where the trade goes first, it needs to get
closed. Invalidation is a critical concept in trading that helps traders
manage their risk and make more informed decisions. Think of it as a
safety net or an emergency exit in a building. If things don't go as
planned, you know where to exit to minimize damage. In trading terms, if
your trading idea or hypothesis doesn't work out as expected, the
invalidation point is where you acknowledge this and exit the trade to
minimize losses.

Now, why is invalidation important?

1. Risk Management: Invalidation is a cornerstone of effective risk
management. By defining an invalidation point, you're essentially
setting a stop-loss level for your trade. If the market hits this level, it
means your initial analysis was incorrect, and it's time to exit the trade
to prevent further losses.

2. Emotional Control: Trading can be an emotional rollercoaster. By
setting an invalidation point, you're making a premeditated decision

about when to exit a trade. This can help reduce the influence of

emotions like fear and greed on your trading decisions.

3. Account Preservation: Regularly hitting your invalidation point without

managing your risk can lead to significant losses over time. By

respecting your invalidation point and exiting trades when necessary,

you can preserve your trading account balance and live to trade

another day.

Now, let's look at the different types of invalidation:

1. When

2. Where

3. How

Invalidation can sometimes be simple, for example, if the BTC price reaches

$20,000 before reaching $30,000 then our long trade idea is wrong. Often, it

might not be so simple, but HOW and WHEN the price reaches that $20,000 mark

also plays a part as your trading plans get more and more sophisticated.

CryptoCred has covered these concepts excellently and quickly in

his tutorial series. The above classification is elaborated below with some

examples:

1. Where: There is when a specific price level that you expected to act as

support or resistance doesn't hold. For example, if you thought $50

would act as support for a stock, but if the price falls to $49, your idea has

been invalidated.

Example: If the price goes below the blue level, then my long trade idea is no

longer valid.

2. When: Here, the invalidation is tied to a specific timeframe. For instance,

if you expected a coin to pump after an airdrop announcement or the

entire market to pump after a bullish CPI but it doesn't, your idea is

invalidated.

3. Combination of Where and When: This is when you expect the price to

reach a certain price point within a specific time frame after an event

(like a news release), but the price doesn't move as expected.

Or the reason can be technical, like if we have a 4-hour candle close

above $100 today, then that is a breakout from that level and we go

long.

Example:

4. When and How: This occurs when the price movement is less than

expected within a certain time frame after an event. For example, if you

expected a 5% price move after a range low sweep but price moves

only 2 percent and shows weakness, your idea is invalidated.

Or you expected a 10% price swing after Elon Musk's tweet but the price only

moves 2% then you know that effect was not as expected and your idea

is invalidated.

NOTE: Trade ideas can get invalidated even when you are in profit.

Invalidation of trade especially when factoring in the How and When factors

does not always mean your trade has to be in a loss, the idea can be proved

wrong even in profit so the best path forward in such a scenario is to close the

trade in profit and move on to the next one.

Remember, these are just examples. The actual invalidation point will depend

on your trading strategy, risk tolerance, and specific market conditions.

A common question amongst new traders is whether they should have a

fixed stop loss percentage, for example: 5 percent.

Stop loss should be based on TA alone. Every setup is different and fixed

percentage stop loss will not work.

Now, let's anticipate some potential questions you might have:

Q: How do I set an invalidation point?

A: This will depend on your trading strategy and the technical analysis tools

you're using. Some traders might use support and resistance levels, others

might use technical indicators like moving averages or Fibonacci

retracements. The key is to have a clear rationale for your invalidation point

and to stick to it once the trade is live.

Q: What if my trade hits the invalidation point but then reverses in my

favor?

A: This can happen, and it's one of the challenging aspects of trading.

However, it's important to stick to your plan. If you start ignoring your

invalidation points, you can end up holding onto losing trades for too long,

which can lead to significant losses.

Q: Can I adjust my invalidation point after the trade is live?

A: Generally, it's best to stick to your original plan. However, there may be

situations where it makes sense to adjust your invalidation point. For example,

if there's a major news event that changes the market conditions, you might

decide to adjust your invalidation point. But be careful not to adjust your

invalidation point just to avoid exiting a losing trade.

I hope this gives you a clearer understanding of invalidation in trading. It's a

crucial concept that can help you manage your risk and make more

informed trading decisions. Remember, the goal isn't to avoid losses entirely

(which is impossible), but to manage your losses effectively so that you can

stay in the game over the long term.

 The Importance of Risk Management

Risk management is essential for every trading strategy or approach, as a

trader cannot achieve profitability if they suffer significant losses from a few

unfavorable trades. Safeguarding your capital is crucial, as it guarantees

your survival and enables you to recover from challenging periods, whether

they last for a week, a month, or even a year. Now, let's address the first

question: What should be the size of your trading account? Without a doubt, it

is important not to invest all of your money into your trading account. Instead,

it should be substantial enough that losing the entire account would have a

significant impact, yet not so substantial that it would lead to financial ruin.

The table below shows how much profit is needed to recover your losses

during a drawdown. Therefore, it’s important to cut your losses. For example, if

you lose 80% of your capital, you need to make 400% just to break even.

Risk Management

Trading Trident

Before entering a trade, you need to determine your “Trading Trident”, which

is a combination of 3 things:

1. Entry Triggers as per your trading technique

2. Established invalidation levels (Stop loss)

3. Defined reversals (Profit-taking)

Entry Triggers: Entry triggers are your reasons for entering a trade.

Typically, a combination of reasons, also known as confluence,

increases the likelihood of a trade's success and provides a

comparatively more secure point of entry. In the example below, our

entry trigger was the retest of a resistance level that has turned into

support.

Stop Loss: The price in the opposite direction of the trade where the

trade is exited, at a loss. At this level, the reason for the entry becomes

invalidated according to TA and the price can then move in the

opposite direction, probabilistically. The next example shows the

importance of a predetermined invalidation level. The entry was made

on the retest of a resistance that has turned into support, but the price

failed to hold above that level and eventually broke down.

Target: It is the possible price level that the asset might touch based on

previous trends or confluence AND where a possible reversal could

occur. Target is the next path of least resistance from where the price

might reverse.

Risk to reward: (R: R)

The combination of the three key components of the Trading Trident forms

R: R. This ratio denotes how much money you make on a successful trade vs

how much money you lose on being unsuccessful on the same trade.

RISK/REWARD RATIO =(Entry point − Stop Loss Point)

                                              (Profit Target − Entry Point)

               

Let’s take an example:

You buy an asset for $100; you have a target of $200 and a stop loss of $50.

What is your R/R for this trade?

R: R  =  (100 − 50)= 50= 1

            (200 − 100)  100  2

A risk/reward ratio of 1:2 signals that you are willing to risk $50 to make double

Here is an example of the R: R ratio on a chart:

Risk per trade

Most traders agree that it is advisable to limit the risk to 2-5% of the total

account balance per trade. My personal preference is 2-3% risk per trade as I

mostly scalp and the number of trades per month is high.

Some people stick with 1%. The following table demonstrates that even if your

win rate is 60%, there will come a point when you will face five consecutive

losing trades.

It is crucial to survive these situations with enough capital to remain

unaffected, and this is where the calculation of position size and risk per trade

becomes essential.

                               Probability of a losing streak based on your strategy win rate

Probability of a losing streak based on your strategy win rate

Now a question that you might ask yourself is how do traders with low win

rates turn out to be profitable?

Profitability relies on two main factors: R: R and win rate. The win rate is

calculated by dividing the number of winning trades by the total number of

trades and then multiply the result by 100 to get a percentage. For

example, if a trader executes 100 trades and 60 of them are profitable, the

win rate would be 60% calculated as:

Win Rate = (Number of winning trades) X 100

                     (Total number of trades)

The following table illustrates how much R: R is needed for a certain level of

win rate. For instance, if your win rate is 50%, you would break even with an R:R

ratio of 1: 1.

Now let’s say you have an R: R equal to 1: 2, but you don’t know which win rate

percentage would be needed for you to breakeven. The formula is as follows:

Breakeven Win Rate =_______1_________X 100

                                      The sum of R: R ratio

                                                         

                                                                             =   1

                                                                             2 + 1

                                                                              = 33%

Hence a win rate of 33% is needed for a breakeven at 1:2.

Note: Always find your win rate then choose trades with R: R that suit your win

rate.

 Position Sizing

Position size in trading is calculated based on several factors, including risk

tolerance, account size, and the specific trade setup. The goal is to determine

the appropriate size to trade in order to manage risk effectively.

Here's a common formula for calculating position size:

Position size = ____Capital at Risk______________________

                               Distance or Percentage to Stop Loss

Example 1: 

Let's break down the components of this formula in the next

example: You have $10k and choose to risk 3% of that amount. Your stop loss

is 5% below your entry.

Position Size = 300   

                         0.05

                            =$6000

If you wish to engage in trading with a position size of $6k, you have two

options. The first option is to long or short using the full $6k without employing

leverage.

Example 2: 

Alternatively, you could choose to utilize leverage, such as 5X

leverage, which would require a margin of $1,500. By doing so, your potential

loss would be limited to 3% instead of 60%.

Example 3: 

Another example is if you have a capital of $1k and are willing to

risk 1% per trade, which is $10. Stop loss is 5% from entry; what’s your position

size?

Answer: Position Size =  10   

                                         0.05

                                      =$200

Q: How do I determine the right position size for my trades?

Answer: The right position size can depend on several factors, including your

risk tolerance, the size of your trading account, and your trading strategy.

Some traders use a fixed percentage of their account for each trade. For

example, you might decide to risk no more than 2% of your account on any

single trade. Others might adjust their position size based on specific

trade and market conditions.

Q: Can I change my position size after a trade is live?

Answer: Yes, you can typically adjust your position size after a trade is live by

adding to or reducing your position. However, it's important to have a clear

plan for managing your trades and to stick to that plan. Frequent changes to

your position size during a trade can increase your risk and make it more

difficult to manage your trades effectively.

NOTE: I have discussed the basics of position sizing and provided examples

for the same. However, after you have gained some experience as a trader or

simply have been consistently trading for more than a year then you can

increase your position size and take more risk (greater than just 1-2%). This

can be done for high-conviction trades, or in cases where you might have

some insider information as you learn more and network more.

Leverage

Warning: Trading on high leverage is extremely risky and is not

recommended for absolute beginners before you finish this tutorial.

Having said that, leverage trading is also known as margin trading, it allows

you to trade with a larger position size than you have available. Leverage in

trading refers to the use of borrowed funds to increase the potential return of

an investment. It allows traders to open positions that are larger than the

amount of capital they have in their accounts.

Example: 

if a trader has $1,000 in their account and uses 10x leverage, they

can take a position worth $10,000. The broker lends the trader additional

$9,000 to take this larger position.

 Connection between Leverage and Position Size

Leverage and position size are closely related because leverage allows

traders to increase their position size without adding more capital to their

account. However, while leverage can amplify profits, it can also amplify

losses.

If a trader uses leverage to take a larger position and the trade goes in their

favor, they can make a significant profit. But if the trade goes against them,

they can incur a significant loss. This is why it's important for traders to use

leverage carefully and to manage their position size appropriately.

Leverage pros and cons

Example:

 If you are trading at a leverage of 3x, and if you make a loss then

your loss is going to be 3 times larger than if you would’ve traded without

leverage. The more leverage you use the closer your liquidation price will also

be to the price where you have entered the trade. Liquidation means you

have lost in some cases your entire position in the trade or in the worst-case

scenario your entire account balance. If you really insist on using leverage

then I would really recommend to never really go above 5.

Example of 1x leverage: You have $1k as position size, price increases by 1%.

This means you have made 1% of the $1k as profit which is $10. On the other

hand, if the price drops by %1, you lose $10.

Now let’s look at the 3x leverage example: This means now you have $3k

position size, $1k from your own capital and $2k borrowed from the exchange.

If the price increases by 1%, you gain 3% profit on your own capital instead of

1% which is $30. If you close your trade, the $2k will be returned to the

exchange and you keep the $30 profit. On the flip side, if the trade goes

against you, then you pay back the $2k to the exchange, and you lose $30 of

your own capital which is $1k in this case. Never enter a trade with your entire

account size and always use the correct leverage to meet the position size

relative to your own portfolio.

Example 3: Real World Example

Let's say you have a trading account with $10,000, and you follow a risk

management rule where you risk only 2% of your account on any single trade.

This means the maximum amount you're willing to lose on a trade is $200 (2%

of $10,000).

Now, suppose you want to buy a stock that's trading at $50 per share, and

you've set a stop-loss order at $45. This means you're willing to risk $5 per

share.

To calculate the number of shares to buy (your position size), you would

divide the total amount you're willing to risk by the risk per share.

In this case, that's $200 divided by $5, which equals 40 shares. So in this trade,

your position size would be 40 shares.

These examples illustrate how leverage and position size come into play

when taking a trade. By understanding these concepts and using them

wisely, you can manage your risk and potentially increase your profitability in

trading.

Mastering risk management is not just about protecting your capital—it’s about securing your long-term success in the financial markets. The difference between those who succeed and those who fail often comes down to how well they manage risk. By applying the right strategies, staying disciplined, and continuously learning, you put yourself in the best position to thrive.

Remember, trading is a journey, not a sprint. The more you educate yourself, the stronger your foundation will be. Make sure to check out our other blogs to deepen your understanding of trading basics and market dynamics. Keep learning, stay patient, and let smart risk management be your guide to success!

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