Simply having a setup that give you an edge is not enough to be a consistent profitable trader. In order to have a chance to stay in this game for the long haul, you must have a solid risk management plan for your trades.
In this post, I will discuss some of the risk management plans and how one might use them. There is no one size fits all risk management plan. Everyone’s risk management plan is different. The plan must be suited for the individual’s risk tolerance.
Before we discuss the risk management plan, we need to define our risk size or the R size. The risk size is the amount we are willing to lose on each trade we put on. Typically, one should not risk more than 1% of the account size on each trade. It is important to set the risk size to a proper level in order to minimize the probability of blowing up the account when a losing streak occurs. For example, if you risk 5% on each trade, and if your win/loss ratio is 40%, there is a more than 40% probability that you will experience a losing streak of 10 losing trades in a row out of 100 trades. When that occurs, you will end up losing 50% of your capital. But if you limit your risk per trade to 1%, then you will only lose 10% of your capital when a 10 trades losing streak occurs. To recover a 10% loss is much easier that a 50% loss. For a 10% loss, you only have to win back 11% from what is left in your account to breakeven. But to recover a 50% loss, you need to double what is in your account in order to breakeven. Huge difference.
Next, let’s discuss position sizing. Once you have defined your R size, then you can determine you position size for each trade. Before you can determine the trade position size, you need to define the entry and stop loss level. The spread between the entry and stop loss will be use to determine the position size. Here’s the equation for position sizing:
Position size = R size / (entry – stop)
When you put on a trade with the calculated position size based on the above equation, the spread between your entry and stop loss is your trade R size for the instrument you are trading. That is what we will use to determine where are the target levels/profit taking level(s).
Now let’s discuss the various risk management plan. The first one is the risk 1 to make 2 risk management plan. I’m sure many of you are familiar with it in some way. This plan requires you to attain a win loss ratio of over 30% and you will have a positive expectancy. And the other one that is not talk about by many retail traders is the 1.5 to 1 reward to risk. This plan requires you to have a 40%+ win loss ratio to attain positive expectancy. Notice I do not talk about more than 2 rewards to 1 risk ratio because we are talking about swing trading. Swing trading is near term, and we are not looking for a long term trend to make multiple Rs, such as 5, 7, or some claim to make 10. Sure, we can realize these high R multiple if you use a small R size in swing trade. But your win loss ratio will be low if you are using small R size because you will experience more trades being stopped out while you are waiting for high multiple of R return.
Here are a few ways for managing the risk 1 to make 2 plan. The obvious one is to take profit on the entire position once it reached 2R. The other way is take 1/2 the position off when it has reached 1R, then exit the other 1/2 when it hit 2R. This will give you a total of 1.5R return. This is one way to do a risk 1 to make 1.5R. Another way to manage this plan is after you have taken profit at 1R, use a trail stop on the remaining position until it take you out at the trail stop. Just remember, you want your average win to be more than 1R if the win loss percentage is less than 50%. It’s important you test these management scheme with your setup to make sure it provides a positive expectancy.
For the risk 1 to make 1.5 plan, you can take the position off once it reached 1.5R. Or the other way is to take 1/2 the position off at 1.5R and trail the remaining position by 1/2R to go for the 2R. This way, you will get 1.25R if you get stopped out at 1R on the remaining position, or 1.75R if the remaining position hit 2R. Again, test against your setup before attempt to use it on real trades.
There are many variations on manage these plans. I’m sure you could come up with other modifications by using trailing stops, breakeven stop, etc. As I said earlier, there is no one size fits all. It’s all come down to what is your risk tolerance.
Let me illustrate with an example. I will use the stock MMM from the previous post “Swing Trading Strategy.”
Here’s a chart of MMM that I have posted on my Telegram private channel to document the time stamp to show this is a realtime chart:
This is the expanded version of that chart:
Here is the latest version with the R levels marked off. Those levels are simply the levels I set using the Fibonacci retracement tool. In addition, I use 1.45 instead of 1.5 to front run it a bit. The scenario that gave us the trade trigger was the blue one.
Here are the trade levels:
The entry level is 99.67
The stop loss is 97.79
The possible upside target is 104.74, more than meeting my 2R minimum
The 1R is at 101.65
The 1.45R is 102.54
The 2R is at 103.63
As of today, the high was 103.66, 3 ticks above the 2R level at 103.63. Using any of the above management plan, this trade has met the profit objective.
I hope you have enjoy reading my posts on how I identify and establish support and resistance levels, and how I use these levels (zones) for swing trading, and how I manage my risk. If you like to read my future swing trade posts and follow what I’m watching for swing trades, then sign up for a monthly plan to try it out for a month. If within a month, you do not find it to be suitable for you, simply cancel your monthly subscription. I believe the educational value alone is worth more than the $15 a month. Sign up now, you will also get my daily trade plan for the ES and SPY, and be able to join the paid subscribers chat community.
In the coming week, I will start posting my swing trade watch on a weekly basis, and provide update when needed through either chat or a separate post. Looking forward to have you come along.
Disclaimer: The contents in this newsletter are just my opinions. They are presented here for educational and informational purposes only. They are not investment or financial advice. Conduct your own due diligence and consult your financial advisor before taking any risk in the financial market.