Day Trading Risk Management is the most important concept that should be the top priority of experienced traders. Many times, we, as traders, focus on our trading strategy or on the profits that we want to earn rather than first starting with risk management. This article will discuss the importance of risk management and how to incorporate it into your trading plan.
What is Risk Management?
In general, day trading risk management is a way to manage the loss incurred from a single trade. As you are aware, not every trade entered will result in a win or gain. Thus, risk management allows the trader to manage the amount their account will be affected when a loss happens.
It is similar to a home insurance policy that protects from catastrophic events like a hurricane, fire, or tornado. Risk management protects your trading account from a loss or a streak of losses, as they are bound to happen to all traders (day traders, swing traders, or even long-term investors).
Defining Risk
Day and swing traders usually set their day trading risk management strategy to not lose more than 1-2% of their account on a single trade. For example, if you had a $5,000 trading account, you would not risk more than $50-$100 on any given day trade.
Sticking to the 1% loss concept would allow you to trade at least 100 times before blowing up your account. It is improbable that you would lose 100 times in a row, but remember that one of the primary goals of risk management is to prevent a blown-up trading account.
You have probably read countless stories from day traders who have blown up one or multiple trading accounts. Many times the issue was not in the trading strategy that they used. The underlying problem was their lack of risk management to assist them in controlling the trade.
A trader can have the best strategy, but if they fail to execute it correctly and do not manage their risk, it will ultimately become a losing strategy.
Benefits of Risk Management
#1 – Allows You to Trade the Next Day (Top Reason)
A day trading risk management strategy in your trading allows you to trade the next day and not merely blow up your account in a single day.
#2 – Helps Your Trading Psychology
You will have greater confidence in a trade when you are not over leveraging your account value and risking more than you should. This risk management strategy will reduce worry and anxiety if the stock price does not move in your favor. You will be confident to try again, as you have not incurred a significant loss in your trading account.
#3 – Know How Much Can Be Lost
With day trading risk management, you can set up your trades with a designated amount that can be lost. By setting up a specified amount, you will feel more in control over the trade management.
#4 – Tracking Trades Made Easier
It allows you to track your trades more quickly to get an idea of how much you are winning and losing per trade. It enables you to analyze your strategy’s effectiveness better to determine if you need to change it.
Day Trading Risk Management Tips
Tip #1 – Know Your Risk Before Entering
Before entering a trade, know how much you are willing to lose on each trade. If losing $50-$100, you need to set the number of stock shares or options contracts purchased. Your calculations will also need to factor in the price of the shares or options contracts and how far you are willing to let the prices move opposite your direction. Many risk management calculators are available online to help you calculate your risk for each trade.
Tip #2 – Do Not Lose More than 1-3%
This concept was previously mentioned, but it deserves another mention. Your number one job as a day trader is managing your risk and maintaining as much of your trading capital as possible.
Keeping your risk a small percentage of your trading account (the one percent rule) will allow you to come back the next day and trade again from your account and not deal with the psychological effects of having a blown account.
Tip #3 – Ensure Feasible Risk Reward Ratio
Many strategies support making small gains while risking more money than the amount gained (for example, attempting to make $50 for a loss of $100). Some traders find these strategies to work if they can win 2-3 times more than they lose. However, in most cases, you want to win more gains than the amount you lose on a single trade.
Tip #4 – Think Every Trade Will Be Loss
Always have a winning mindset when trading, but also assume that the trade you enter may result in a loss. So, do your part in minimizing the risk to your account. But, ensure that you accept the chance that the trade may result in a loss and not be a winner.
Tip #5 – Minimize Open Positions
Another day trading risk management tip is to minimize the number of open positions in the market at a given time. You probably have seen stock prices drop quickly due to negative market news.
Having many positions open during these catastrophic news events could allow you to incur multiple losses, which could negatively impact your account all at once. You limit significant account loss from numerous trades by only having a few positions open.
Tip #6 – Limit Positions in the Same Sector
Similar to the last tip, you also want to limit open positions in the same sector. For example, if you have open positions in the oil sector and there was negative news that was released related to oil, this could cause your oil positions to be negatively affected.
Thus, if you decide to open multiple positions, ensure they are in different sectors. Example sectors include Consumer, Energy, Transportation, Financial, etc.,
Day Trading Risk Management Strategy
So, let’s now discuss trading strategies to manage risk. Your first step is determining the amount of money you are willing to risk. Once this is determined, you will need to calculate the number of shares or contracts you can purchase based on the amount at risk and where your potential stop loss will be.
We recommend setting stop losses on technical analysis charts at key levels, like support and resistance or supply and demand zones. It is best to determine the stop loss placement and then perform your calculations.
Physical Stop Loss
Once this is determined, decide whether you will use a mental or physical stop loss. A physical stop-loss is where you allow your trading platform to exit out of your trade if it hits your stop loss.
Mental Stop Loss
A mental stop loss is where you exit the trade manually if your set stop loss is triggered. Some traders may choose a mental stop loss to prevent hedge funds and computer algorithms from hunting for their automated stop losses to take out the average retail trader.
The drawdown to having a mental stop loss is that some traders may fail to manually execute the loss, hoping the trade will turn back in their favor. This process could cause them to incur even more losses.
Traders can use many automated stop losses: stop-limit orders, stop market orders, and trailing stops. The type chosen will depend on how the trader desires to exit their trades. Here is a summary of each of these types:
- Stop Market: Allows a market order to be executed once the condition has been met (i.e., the set price has been reached)
- Stop Limit: Allows a limit order to be completed once the criteria have been completed (i.e., the set price has been reached)
- Trailing Stop: Allows the stop-loss order to gradually move in the direction of the trade to allow the trader to obtain profits gained.
Summary: 6 Tips for Day Trading Risk Management
Have you incorporated risk management in your trading strategy and plan? The benefits of risk management far outweigh the negative effects of not having a plan in place. Having a risk management plan will help boost your confidence in earning money while day trading.
Maurice Kenny is a profitable trader that wants to help you in learning how to day trade the proper way and in learning how to include risk management in your strategy.
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