Risk Management Rule for Traders

By | March 26, 2013

A random person is pulled off the street and given 100,000 to trade.  They have no prior experience which, on the bright side, means they have no bad habits, emotional baggage, or preconceived notions.  Before trading they go through a five day crash course on market basics (order entry process, chart reading, pattern recognition, etc…).  Suppose you are tasked with the responsibility of drafting a set of risk management rules which they are required to abide by.  The objective is to make them survive as long as possible in the trading arena so they can learn as much as possible through first-hand experience.

What types of rules would you set?

The ideal approach of course is to structure a set of rules which makes it as difficult as possible to blow up the account while still leaving them open to accumulating profits.  The goal isn’t so much helping them capture large gains as much as it is helping them survive.  After learning how to survive, then they can modify their approach to being more aggressive and seeking larger gains.

Here are two of my top rules:

1.  Risk 1% per trade. Position size properly so if you are stopped out you only lose 1% of your total account size.
2. Time Diversification. Stagger your entry into new trades over time. This diminishes the odds of incurring your max loss on multiple trades simultaneously.

By diversifying your entry to new trades over time you not only lower the chances of hitting your max loss on multiple positions, you also reduce the total amount of your account at risk at any given time. Suppose you entered eight new bullish trades today with 1% of your account at risk in each position.  While you’re positioned to profit handsomely if the market rises, you could incur up to an 8% loss tomorrow if the bottom falls out of the market.  Those wishing to avoid a loss of that magnitude ought not load the boat with 8 new positions at once.

There are not doubt other risk management rules worthy of including in a set of rules for this particular game.  The interesting thing is it isn’t a game.  It’s real life for most traders and the objectives are the same.

First learn to survive, then you can up the ante and seek additional profits.

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