Risk Management Definition

Risk management is crucial because all trading strategies lose sometimes. By limiting risk, a trader has a chance to survive long enough to find a way to thrive. The topic is way too big for my little glossary but its here because I want to encourage traders to think about risk.

Extra Insight:
Funny Carrie Underwood parody reminder to manage risk:

Backtesting trading strategies provides insight into the risk of various trading strategies. Understanding risk is the first step towards managing it. A complete understanding includes the knowledge that there’s always the risk of something completely unknown and unforeseen happening.

Different people have different risk tolerance and even the same person will view various risk differently. That means you have to decide for yourself what to risk.

Here are a few “rules of thumb”:

Don’t risk more than you can afford to lose.
Limit the risk on each position. 1% of your trading account risked per stock is a middle-of-the-road estimate. By risked, I mean the amount lost if the stop is hit. No stop? Then limit the size of the whole position to a small fraction of your account.
Limit the total exposure of your account. What happens if all your stops get hit? What happens if the market gaps past all your stops. Make sure you can handle it.
“Blowing up” means losing 50% of account value. Don’t let that happen!

Here’s a link to the book advertised in the video: Mastering the Trade (McGraw-Hill Trader’s Edge).

(Backtesting Blog is an Amazon Associate.)

Updated 11/12/08.