Trading Risk Management: How to Control Losses and Protect Your Portfolio
Money Management: The Forgotten Discipline in Trading
Money management is like sex: everyone does it one way or another, but not many like to talk about it, and some do it better than others. But there’s a big difference: while sex-related websites are everywhere online, websites devoted to the art and science of money management are far harder to come by.
Many financial websites offer portfolio tracking tools that are essentially glorified watchlists. You input your positions and receive a snapshot or, better yet, a real-time update on the status of your stocks based on current prices. Sites like Fidelity even provide insights into how your portfolio is allocated across asset classes like stocks, mutual funds, bonds, and cash.
However, most of these platforms fail to address the core question of money management: “When I make a trade, how much should I trade?” Tools that help traders determine position sizing and risk management are rare, even on major sites like The Motley Fool.
This article explores how to measure and manage trade risk responsibly and profitably. The central concept is to control how much you’re willing to lose on any single trade.
When a trader decides to buy or sell, they must also determine the size of the position. Every brokerage order form includes a field for quantity. The essence of risk management is making a logical decision about how much to buy or sell in this field. The size of your order determines the risk of the trade. If you accept too much risk, you’re more likely to go bust; too little risk, and your profits may not cover transaction costs and overhead. Good money management is about striking a balance between these extremes.
Overtrading and Undertrading
A graph (Figure 1) would typically illustrate how the long-term result of a series of trades correlates with the amount of risk per trade. If you risk too little per trade, known as undertrading, your returns won’t be sufficient to offset transaction costs and minor losses. On the other hand, risking more can yield higher returns but also leads to greater drawdowns. Trading at peak return levels is psychologically taxing due to high drawdowns and minimal margin for error. One big loss could wipe you out.
The optimal zone is where you can psychologically handle the drawdowns required to achieve maximum return. Money management acts like a thermostat—a risk control system that keeps your trading in the comfort zone.
It’s More Than Just Stops
Surprisingly, many traders don’t fully understand money management. They associate it with setting stops and having the discipline to stick to them, but their understanding often stops there. Most rely on brokers to track trades, and while these tools are helpful, they rarely offer deeper risk management capabilities.
Online broker rating services and most trading platforms don’t highlight brokers that offer robust risk management tools. This neglect may be due to the extended bull market since 1982, particularly the tech-fueled rally from 1997 onward, where buying the dip often led to easy gains. In such a market, perceived risk is low, making money management seem less urgent.
Two Types of Players
Market participants generally fall into two categories: traders and investors. Many who call themselves traders are actually active investors. Investors typically buy as many shares as possible with available cash and hold for the long term, believing that markets always rebound. When they have more funds, they buy more stocks or mutual funds.
This approach is akin to hitchhiking on a freeway that only goes one way. Investors hope for the best but may not know when to exit a failing position. Many believe the market will always bounce back, so they hold or double down to reduce the average cost.
Traders operate differently. Unlike investors, traders treat each position with objectivity. They use risk management tools like brakes and seatbelts to protect against large losses and ensure they can maneuver quickly in volatile markets. Their success often hinges on controlling losses rather than chasing gains.
Poor traders bring investor habits into trading: they trade on margin, use credit cards to buy more stocks, and ignore the risks of high leverage. They enter the trading world in a borrowed luxury car but don’t know how to use the brakes or fasten their seatbelts.
Money Management Tasks
To manage money effectively in trading, you should:
- Determine how much you’re willing to risk on each trade.
- Understand the risk of each trade and size positions accordingly.
- Monitor each trade’s progress.
- Act on risk points quickly to avoid large losses.
- Regularly review your performance.
Determining Per-Trade Risk
The most important decision is how much of your portfolio you’re willing to risk per trade. Top traders often limit this to less than 2%. This minimizes the impact of a losing streak.
Understanding Trading Risk
To gauge a trade’s risk, decide your exit price before entering. This could be based on a technical stop-loss or a predetermined amount you’re willing to lose.
For example:
S = er / (p – x)
Where:
- S = trade size
- e = portfolio equity
- r = max risk percentage per trade
- p = entry price
- x = stop-loss price
If Belinda has $100,000 and is willing to risk 2%, she can risk $2,000. If DTCM is trading at $100 and her stop is $95, she can buy 400 shares.
Alternatively, if she wants to short KRMA at $40 but has no technical stop, she can use:
x = p(i – er) / i
Using core equity (equity minus value at risk) instead of total equity helps automatically reduce exposure when volatility increases.
Tracking Your Trades
Always track positions and adjust stops as prices move in your favor. For example, if DTCM rises from $100 to $120 and the stop remains at $95, the risk grows from $2,000 to $10,000. Never treat profits as “house money.” Always move stops forward to lock in gains.
Terminating with Prejudice
A money management plan is only effective if you follow it. Stick to your planned stops. If stops frequently get hit, reassess your trading system—not your discipline. Exiting trades with small losses is crucial. Never let hope guide your decisions.
Discipline is paramount. If a stop is hit, take the loss. If the stock recovers and turns profitable, you’ve been rewarded for bad behavior, which is dangerous. Instead, exit, reassess, and reenter if appropriate. Faith and hope belong in religion—not in trading.
Reference Links:
Investopedia | EarnForex | Recommended Brokers