Chapter 1-Learn How To Manage Risk In Day Trading

Risk management is one of the key ingredients of a successful day trader. If you are great with trade idea generation and good risk management, chances of you succeeding as a day trader is high. In the process of becoming a professional day trader, you might change your risk management methods several times based on your changing requirements. From position sizing to fixing risk-reward on your trades, everything falls under risk management. Now let’s look at what exactly is risk management in day trading.

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What is Risk Management In Day Trading?

A well-planned approach to reduce the overall risk involved in trading due to uncertainty in price fluctuations in the financial market is known as risk management.

Risk Management Definition

Risk Management Techniques

When it comes to day trading, risk management is divided into two categories,

  1. Overall Capital Risk
  2. Risk Per Trade

Overall capital risk

Assigning an overall risk that you are willing to lose on your entire capital is known as overall capital risk. For example, if you are willing to day trade with a capital of $1000 or Rs 1000, you should determine how much are you willing to lose in total before taking any trades. Let’s assume that you have decided max acceptable loss of 25 % on your available day trading capital. This means you can’t afford to lose more than $ 250 or Rs 250 on your entire capital. You should consider this very seriously if you want to succeed as a day trader.

What should you do if the overall capital risk is exhausted?

Make overall capital risk the most important aspect of your day trading career. Once you have exhausted the overall capital risk defined by you, make sure that you withdraw the rest of your available trading capital. This will reduce the chances of losing your entire capital at once when you are day trading. Take a few days off from the fluctuations of the market, if you reach this limit. Stay away from markets for a while. Check and learn from the mistakes you made in your past. If you have been stopped out of markets multiple times in a continuous manner then you should look to improve the accuracy of your day trading strategy.

Next steps after deciding your overall capital risk.

The next obvious step is to allocate risk per trade. By including overall capital risk and risk per trade in your day trading routine, you are preserving your capital for a longer day trading career. Always remember that your goal is to trade for a living which means you have the choice to trade for your entire life. With a single loss, nothing big is going to happen. Losses are just a part of day trading. So now let’s look at what is risk per trade and how should you use it.

Risk per trade

Assigning a maximum percentage of loss on your available capital for every individual trades is known as risk per trade. In the above example of overall capital risk, we assumed 25% max loses risk i.e. $250 or Rs 250 was the overall capital risk. You can lose this overall capital risk of 25% in one trade or you can choose to lose this 25% risk in 50 trades or even 100 trades if you are a very conservative trader. So if you choose 100 trades, it means your risk per trade should not exceed $2.5 or Rs 2.5. It would take 100 continuous losing trades to reach your overall capital risk. Do you think it’s easy to get stopped out 100 times continuously in day trading? I don’t think so and it would one of the most difficult things to happen. Now that you have understood what is risk per trade and how you can preserve your capital by using risk per trade, now its time to learn the third important aspect of risk management in day trading i.e. risk-reward ratio.

Risk Reward Ratio In Day Trading

Risk and reward are the two sides of the same coin in day trading risk management. Always think about how much you can lose in a trade first and then look at how much profit you can make from a trade. If you can lose $1 or Rs 1 per trade on a particular trade which can yield you a maximum profit of $1 then your risk-reward ratio is 1:1. With a risk-reward ratio of 1:1, you need to be right at least 60 % of the time to yield a net profit. This means out of ten trades, you need to make a profit in six trades minimum.

You need a trading strategy with 60 % accuracy to make profits from day trading if you are using a 1:1 risk-reward ratio. But in day trading chances of getting stopped out often is high. So you need a better risk-reward ratio. Few day traders might use a risk-reward ratio of 1:2, which means with just a 40% accuracy trading strategy they will be able to make net profits.

So if you are using a 1:2 risk-reward ratio, you need to be right 4 times out of ten trades to make net profits. But I always stick with a minimum risk-reward ratio of 1:3 which means I need to be right only 30 % or three times out of ten trades to make profits, which is highly possible in day trading. Take a look at the below example to understand how 1:2,1:3 risk-reward ratio works.

Risk reward ratio of 1:2 example:

If you lose in 6 trades out of 10, your net profits will be,

  • Total Number of Trades- 10
  • Per trade loss- $1 or Rs 1
  • Per trade profits-$2 or Rs 2
  • No of losing trades-6
  • Total loss-6*1=$6 or Rs 6
  • No of winning trades-4
  • Total profit=4*2=$8 or Rs 8
  • Net profit= Total profit – Total loss=8-6=$2 or Rs 2

Risk reward ratio of 1:3 example:

If you lose in 7 trades your net profits will be

  • Total Number of Trades- 10
  • Per trade loss- $1 or Rs 1
  • Per trade profits-$3 or Rs 3
  • No of losing trades-7
  • Total loss-7*1=$7 or Rs 7
  • No of winning trades-3
  • Total profit=3*3=$9 or Rs 9
  • Net profit= Total profit – Total loss=9-7=$2 or Rs 2

So with the above-explained example, it’s clear how you can make profits with a risk-reward ratio of 1:3 in day trading. With a day trading strategy of 30 % accuracy, you can make profits in day trading. We have not discussed brokerage fees and transaction fees in the above-discussed examples. You have to reduce all additional day trading charges from your net profit to see your actual profits. By using trailing stop loss, your overall loss can be further minimized and chances of you making net profits are higher.

Further to improve your day trading performance, use your trade statistics which you might have created by regularly logging your trades into a trade journal. If you need more accuracy, improve your day trading strategy by adding some additional filters like adding an indicator or choosing a little higher time frame, etc. Once you understand and implement risk management in your day trading, the next step to learn is position sizing. So keep learning and proceed to chapter two of this day trading guide. Go to Chapter 2 – Position Sizing.

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