Risk Management for Traders During Volatile Times Like These

07/21/2008 12:00 am EST

Focus: STRATEGIES

Tom Busby

Founder and CEO, DTI

Risk management for a trader can be compared to that of swing control to a golfer.  It is one of the most important skills a trader must master.  If a golfer were to wildly swing his club at a ball his chances of successfully striking the ball diminish.  Just as if a trader were to wildly click the mouse in and out of the market, chances of profiting diminish.  Therefore, to win the trading game, you must become educated and have discipline and follow a risk management policy, inherently reducing risk.

There are many steps involved in creating a risk management plan.  You must first determine your level of risk tolerance.  That answer is different for everyone with one thing remaining the same for everyone, the money put into the market is money that you should not mind losing.  There is a great deal to consider before you decide to put your money at risk, especially when the average range of the S&P is over 35 points.  Prior to entering a trade, you must determine the amount of loss you are willing to incur.  A good rule of thumb is to limit losses to 1-2% of one's total account balance.  If the trade requires too much risk, don't take it.  There will always be another trade.  Be patient.  Once you decide to take a trade, learn to scale out of the position at various levels and always trade with stops.  Many novice traders (and some experienced ones) rely on an all-or-nothing approach.  Nothing could be worse. 

Here is a simple example that can be applicable to any market:  If you buy 300 shares of a stock at $10 and exit all at $11, you make $300.  Not bad.  If you buy that same stock and same number of shares and exit 100 shares at $11, another 100 at $12.50 and the last 100 at $10.50, you make $400.  That's over 3% better than the alternative.  When entering a trade, use incremental profit targets and hard stop losses.   

Trading is also a matter of balancing fear and greed and tying that in with the risk.  One successful approach is to take advantage of small moves in the market based off the average range, as that will allow traders to stay in a trade longer as it develops.  Most traders enter a trade and exit the full position only to miss most of the move.  This leaves a trader second-guessing and chasing the market.  If the trade goes against them, the loss is many times greater than the profit that would have been made.  To reduce this frustration, take profits off of small moves, reducing the size of the position thereby reducing risk, and go for the trend breakout on the remainder.   This allows a trader to balance fear and greed as well as minimize the losses.

Here is a trade I took today that allowed me to make money, but also left me wanting more.my discipline as a trader kept me "green" for the day. The idea here is you can not succeed in trading by following the rules a couple of days out of the week, you must follow your rules day in, day out, no matter what the market is doing.  Today, July 15th, I sold the e-mini in the afternoon just after 2:30pm CDT.  My trigger price was 1217.75.  I was in that trade for what seemed like hours-but it was really only about 10 minutes.  I was not seeing the confirmation I am used to seeing in a great trade, and so rather than wait to see if they really broke down, I took profits and headed to the golf course.  The ultimate low of that move was 1210.50.  The old me would have obsessed over the money I left on the table, but the trader I am today knows better. (See Figure 1.1)

Figure 1.1

Every trader knows that all trades do not work like the one above.  Sometimes, even with the best analysis, trades fail.  With these trades, too, one should scale in and out of the position.  That gives the trade a chance to work for the final portion of the position.  If the situation looks too grim, just exit the entire position.  A loss will be suffered, but it will be relatively small.  By scaling out of positions as soon as trouble appears, money is saved.

Given the current state of volatility in all markets, the risk is greater, much greater.  You must understand that expanded ranges force expanded stop loss orders.  The markets are extremely fragile and move off of any announcement, rumor or fact.  If you are trading, consider wider stop up to one third of the average range of the market.  If this is unbearable to you, save your money for less volatile times. 

No strategy can prevent trading losses; however, scaling out of trades, keeps fear and greed in check.  Make it a point to give yourself every opportunity to become successful; be in control of your swing.

By Tom Busby

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