Risk management (R)

When I read about daytraders and investors describing their performance, I often see messages like:

Yesterday I made 10% of XYZ share

Or

My daytrading yesterday yielded 25 points / pips

This is the most common way of describing one’s results.

The problem is that it is a deficient description that makes it difficult to compare the results from one’s different methods and, not least, difficult to compare results between two daytraders.

What is missing?

Reward always needs to be compared to the risk taken

What is lacking in the above description is how much a risk was taken on the individual investment.

There is a big difference if you made 10% in return and risked 90% of your capital, or you made 10% in return and only risked 2% of your capital.

The first investor who risked 90% of the capital whose stop-loss was hit can only account for one of these errors, so the capital had more or less disappeared. Whereas the other investor who only risked 2% of the capital can hold 10 losing trades in a row and would still only be 20% in minus.

How is risk defined?

The way I use to define my earnings in relation to my risk is first defined by “R”.

1 R is the number of points / percent I risk if my investment goes the wrong way.

Let’s look at a concrete example here from a trade in the German DAX index.

Above, we see a good profitable trade on 1-min chart.

I’m going long at 9420 and put my stop-loss at 9410, which means I risk 10 points in total. The 10 points I now call 1 R.

The trade is happily in the right direction, and I’m out of business with 30 points in winnings.

Now I divide my winnings (30 points) with my risk (10 points), giving 3. My win is thus 3 times as big as my risk, which means my trade has given 3 R in winnings.

Had the trade gone against me and I had lost 10 points, then the outcome would have been – 1 R.

What can we use this for?

Many traders immediately think that all this talk about R / risk is a bit insignificant as long as you have a profit in the account. But when looking at successful daytraders and investors, they always have a highly disciplined approach to risk management.

As mentioned earlier, this principle about “R” can be used for more things in practice, but the most important feature is that you can keep your risk constant for each trade.

I have set my personal risk at 0.5% per trade. That is, if my first stop loss is hit, I know that I only risked 0.5% of my total capital.

In the trade above from DAX I know that I risk 10 points. If my capital is on 100,000 kr., then I can lose a maximum of 500 kr. per trade (0.5% of 100.000 kr.). Then I divide 500 kr. With the 10 points at risk, which means I have to bet 50kr per point on my trade. This way of controlling the risk makes me recall all my losses and gains measured in R in my trading journal after the trading session ends.

As long as it is calculated in R units, it is easy to compare two different trading methods, different days, different time frames, etc.

Optimizing your method

Another thing that this risk management can be used for is to optimize your method.

If you have made 100 trades in one month and you in your journal can see that your maximum drawdown (the biggest loss at any time) is on for example. 8 R, then you can begin to wonder whether you should risk a larger percentage of your capital per trade.

If you have initially been conservative and only invested 0.5% per trade, reviewing your logbook might increase your risk to 0.75% per trade. It gives you a greater return with a risk that you can tolerate.

All successful traders use this principle

All the really successful daytraders I’ve met in my career have used some variation of the above risk management. It has ensured that they constantly know their risk, never take too much risk but, in return, do not risk too little per trade.

As it may seem like a dull and dry approach to daytrading, it’s a discipline that will significantly increase your chances of success.

And keep in mind the good old saying:

Trading should be about as exciting as looking at paint dries. If you want excitement, then go to Las Vegas.

So add R as risk management in your daytrading and become a successful daytrader.

Video

Below is a video that expands on the article and provides more examples.

Hans Henrik Nielsen

Hans Henrik Nielsen is a very experienced day and swing trader, teacher and publisher, who in the last couple of years has produced 80-134% profit on his day trading.

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