The most import aspect of your trading strategy is your risk management methodology. Before you begin to risk capital, you need to solidify the risk you will take relative to the reward you are looking to capture. There are different risk management strategies you can consider employing depending on how you plan to invest in the market. If you plan on day trading, you need to have specific risk parameters compared to long term investing. You also need a risk strategy for your entire portfolio.
What is Risk?
Risk is defined as the capital that you are willing to lose when you place a trade. Before you place any trade, you need to determine the amount you will risk, relative to the amount you plan to gain. The ratio between the amount you will gain relative to the amount you lose is referred to as the reward to risk ratio. The risk that you take should be predicted on the type of trading strategy you plan to employ.
If you do not have a sound risk management plan in place, you are skating on thin ice. Most novice traders initially think about the gains they plan to generate when they trade and fail to determine the risk they will take when they begin to invest.
How to Define a Risk Management Plan
Your risk management plan should be embedded into your investment strategy. You can start by determining your financial goals and back into you risk management. If your strategy is a trend following strategy, you are likely going to lose more than you win and therefore need to make more on each trade than you lose. Here is the math. If you lose 2 out of 3 trades, then you need to make twice the amount on your winning trade than you lose on your unsuccessful trades. If you lose $100 on each losing trade and make $200 on your winning trade, you will break even.
If your strategy allows you to win more than you lose, then you can afford to have a risk management plan where you lose more on each trade than you win. If you are planning to undertake short-term trading, your strategy should be designed around how much you are willing to lose on each trade. You can then back into the financial goals you have for each trade.
Each transaction you place should have a stop loss and a take profit level defined prior to executing the trade. Some strategies can have a moving target where you move your stop loss to reduce your risk as the market moves in your favor. This is called a trailing stop loss.
You also need to separate the difference between your risk management on individual trades relative to the risk management on your overall investment strategy. Not only do you want to have a stop loss for each individual trade, but its also prudent to have a stop loss on your overall investment strategy.