This article originally appeared at The Option Pit written by Morgan from The Trading Pub. This is an excellent article for beginning traders. Professional traders will be well aware of the concepts. I've highlighted parts of the article to emphasize key points. As I've said many times before and I'll tell you again; If you can't find a trade where the reward is 2x the risk... pass on the trade.
Enjoy Morgan's Article:
Risk Management, the Great Equalizer:
Many traders make excuses for reasons they lose money. These can range from blaming market makers, high frequency traders, bad fills, your broker, etc. The main reason we have found that traders lose money actually does not involve any of those things mentioned, but rather the risk management technique used by the trader. It has been said that you can make money with almost any method if you have proper risk management and to a certain extent we believe this to be true.
It has been proven over the years that trading is a transferable skill and along with education, it is important from the beginning to understand the importance of risk management.
Let's look at a couple of case studies:
Example 1: Trade is entered and a stop of $3.00 is used for a profit of $1.00. This is a trade many traders take in the sense they look for small gains with a large amount of risk. This trade tends to work out the majority of times but rarely works out enough to make money over time.
- With the above risk/reward of 3/1, the trader would have to be correct close to 75-80% of the time just to BREAK EVEN after commissions! Ask anyone who has been in the business for a while and 80% is not something easily achievable. Keep in mind that 80% is just to break even... to make money an accuracy rate of close to 90% is required.
Example 2: Trade is entered and a stop of $2.00 is used for a profit of $1.00. This is a trade that also tends to work out the majority of times but will still require a high probability of success.
- With the above risk/reward of 2/1, the trader would have to be correct close to 65-70% of the time to break even after commissions (note that many traders do not factor in commissions when evaluating their results and this is a major mistake). While this is not quite as high of a threshold as Example 1, a very high accuracy rate is required before making the first dollar.
Example 3: Trade is entered and a stop of $1.00 is used for a profit of $1.00. This is a trade that will take more stop outs than the two examples above but by cutting the losses down, gives the trader a more reasonable expectation of making money over the long haul.
- With the above risk/reward of 1/1, the trader would have to be correct about 55-60% of the time to break even factoring in commissions.
Many people tend to live in denial as far as their risk/reward and while the figures above make sense, many continue to trade with a high amount of risk and take very small profits. The best thing for each trader is to keep track of their trades and understand their accuracy rate. Their accuracy rate along with their risk/reward on gains/losses will allow the trader to be able to back into a scenario where they have determined what ratio works for them. For example, if I am only right on my trades 60% of the time, I cannot feasibly take trades that require me to risk $2 to make $1 which means some trade setups have to be passed up as I wait for one that fits my risk profile. In order to keep risk low, losing trades cannot be allowed to run deeper and deeper. Any real trader will tell you they are not going to be correct 100% but the reason they make money is their gains outweigh their losses at the end of the day. They have learned the discipline of managing risk to maximize reward. Along with their knowledge and experience, it makes a potent combination.
The bottom line is this: If you keep track of your trades and analyze your risk/ reward based on your actual trades, you will learn more and more about yourself as a trader and therefore increase your odds of becoming a successful trader.
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*Special thanks to Option Radar, BMO Capital, MEB Options, LiveVolPro, CBOE, Option Monster, T.O.P. group, and all of the options desks and traders we work with to provide the option flow!
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