Before you place a trade, you should have a clear idea in your mind of what you are willing to risk. In addition, you want to make sure you have an idea of the type of profit you are looking to generate. If you ride by the seat of your pants, you are likely to get into a situation where you are unsure what you should do and begin to doubt your initial investment thesis. There are a few calculations you should understand, and go throught this process each time you are preparing to place a trade.
There are two types of returns you can generate, riskless returns and returns that require risk. If you want a riskless return you can invest in a government note. During 2019 this provided small positive returns in the United Stats, while in the Euro zone and Japan these returns were likely negative. A risk free return is one where there are no market or credit risks. When you purchase a US treasury bill you have the full faith of the US government and expect repayment.
Table of Contents
How to Measure Risk
Risk is the amount that you could lose on a trade. Its not the actual loss. When you place a trade you should have a clear idea of how much you are willing to lose. With that in mind, you can then calculate how much you should try to make. The ratio of how much you plan to make compared to the amount you are willing to lose is a risk-reward ratio.
To successfully make money you need to win more than you lose, or gain more on winning trades than you lose on unsuccessful trades. For example, if you place 9-trades and you win 5 and lose 4, the risk to reward on each trade could be the same. Instead of you place the same number of trades and lose 6 and win 3, you would need to make twice as much on each winning trade as you would lose on an unsuccessful trade (3 * $100 = $300 compared to 6 * -$50 = $300).
Creating a Strategy with Risk Management
Your risk management techniques should be incorporated into your trading strategy which will provide you with a business plan for each trade. Not every trade needs to have the same plan, but if you find a successful model, you should continue to take advantage of its success.
Take Away
To successfully trade the capital markets, its helpful to have a trading business plan that incorporates risk management. Risk management determines how much you are willing to risk to achieve your financial goals. Each trade that you place should have a stop loss level and a take profit region. If you change the point where you will take profit as the market moves your way, make sure you alter your stop loss.
Before you place a trade, calculate the potential risk/reward ratio. Remember you get paid to take risk beyond the risk free rate of return. You will not win every trade, and your goal is to find a ratio that will allow you constantly to make money with risks that are actively managed.
