Risk management is one of the more important features of a trading strategy. It determines how much money you will risk to generate the rewards you want to receive. Most novice investors initially think about how much money they will make on an investment strategy without considering how much money they could possible lose. Before you begin to trade a trading strategy you should define in advance how much money you are willing to risk per each trade, as well as how much you are willing to risk on the strategy.
Risk Versus Reward
The risk you take relative to the reward you receive, can be different for each type of strategy. The ratio of reward to risk should vary. If you win more money than you lose on each trade on average, you can win fewer times than you lose. Conversely, if you make less than you lose per trade, than you need to win more than you lose on each trade to be successful.
For example, you might consider a trend following trade. The goal of a trend following strategy is to ride the trend until it reverses. In this instance you are likely trying to win more money than you lose as you ride a trend.
One of the best trend-following strategies is a moving average crossover trading strategy. This is a technical analysis strategy. Unfortunately, there are many false signals as the moving average chop around. Once the trend is in place, the strategy pays off handsomely, but you could face many losers before the trend takes hold.
Alternatively, you might look at a mean reversion trading strategy, such as a Bollinger band trading strategy. Here you might be willing to lose more money on each trade compare to the amount you win on each trade since you are attempting to win more times than you lose.
Here are some calculations, that describe the amount you would need to win if you only had a 33% success rate on your trading strategy.
When you win 33% of the time and lose 66% of the time, you need to win twice as much on each trade successful trade compared to what you lose on unsuccessful trades. If you have 100 trades, 33-wins at $20 each ($660) and 67-losses at $10 each ($660).
Setting Your Goals
Before you begin to trade a strategy, you should determine what your goal is and how much you would be willing to lose. You should start by evaluating your investment and determining how much you want to make. You should then see if the opportunity allows you to risk an amount that is reasonable. You should not expect to make 100% profits while only risking 2%. A more realistic goal would be to make $3 for every $1 dollar you risk. By setting realistic goals and evaluating your risk-reward before you begin to trade, you will develop a trading plan that you feel comfortable with and you can follow despite the volatility you might experience when trading the capital markets.