Risk Management
Master the art of protecting your capital while maximizing returns. This comprehensive guide covers position sizing, stop losses, portfolio allocation, drawdown management, and the psychology of risk - the most important skills for long-term trading success.
Risk Management Is Everything
The difference between professional traders and amateurs isn't strategy quality - it's risk management. Professionals survive and compound gains. Amateurs blow up their accounts. You can have the best strategy in the world, but without proper risk management, one bad trade or market event can wipe you out.
The Foundation: Risk Per Trade
The 1-2% Rule
Never risk more than 1-2% of your account balance on a single trade. This is the golden rule of risk management.
Example:
Even though position is 50% of account, maximum loss is only 2% ($200) thanks to proper stop loss.
Why 1-2%?
With 2% risk per trade, you can survive 50 consecutive losses (0.98^50 = 36% of account remaining). This gives you breathing room to recover from bad streaks. At 10% risk, you're broke after 10 losses (0.90^10 = 35%). At 20% risk, you're done after 5 losses.
Position Sizing Methods
1. Fixed Fractional (Recommended)
Risk a fixed percentage (1-2%) of current account balance on each trade. Position size adjusts automatically as account grows/shrinks.
Formula:
Position Size = (Account Balance × Risk %) / Stop Loss DistancePros: Compounds gains, limits losses. Cons: Position size varies.
2. Fixed Dollar Amount
Risk the same dollar amount on every trade regardless of account size.
Formula:
Position Size = Fixed Risk Amount / Stop Loss DistancePros: Predictable risk. Cons: Doesn't compound, too conservative when winning.
3. Kelly Criterion (Advanced)
Mathematically optimal bet sizing based on win rate and win/loss ratio. Maximizes long-term growth rate.
Formula:
Kelly % = (Win Rate × Avg Win / Avg Loss) - (1 - Win Rate)Pros: Optimal growth. Cons: Can suggest very high risk (use half-Kelly or quarter-Kelly in practice).
Stop Loss Strategies
Fixed Percentage Stop
Set stop loss at fixed % below entry (e.g., 5%). Simple but doesn't account for volatility. Works for low-volatility assets.
ATR-Based Stop (Recommended)
Set stop at 2-3× ATR (Average True Range) below entry. Adapts to current market volatility. In volatile markets, stop is wider; in calm markets, tighter.
Support/Resistance Stop
Place stop below recent support level (for longs). Based on market structure rather than arbitrary %. More logical but requires chart reading skills.
Trailing Stop
Stop follows price up, locking in profits. E.g., trail 10% below highest price since entry. Protects gains but can exit prematurely in volatile markets.
Time-Based Stop
Exit after X days/hours if position hasn't moved favorably. Prevents capital from being tied up in dead trades. Useful for mean reversion strategies.
Portfolio Allocation
Diversification Across Strategies
Don't put all capital into one strategy. Diversify across:
Portfolio Heat Limit: Sum of all open position risks should not exceed 6-8% of total account. If you have 3 positions each risking 2%, that's 6% total heat. Don't take a 4th trade - you'd exceed safe exposure limits.
Drawdown Management
Understanding Drawdowns
Drawdown is the decline from peak account value to trough. Even the best strategies experience 20-30% drawdowns. How you handle them determines survival.
The Math of Drawdowns:
This is why limiting drawdowns is more important than maximizing returns.
Drawdown Reduction Techniques
- Reduce Position Size: When in drawdown >15%, cut position sizes by 50% until recovery
- Pause Trading: If drawdown exceeds 25%, stop trading entirely. Review strategies and market conditions
- Diversify Uncorrelated Strategies: Mean reversion + trend following rarely draw down simultaneously
- Use Correlation Limits: Don't run 5 BTC strategies - they'll all lose together. Mix BTC, ETH, SOL
Correlation Risk
The Hidden Danger
Running 10 strategies sounds diversified until you realize all 10 are long BTC. When BTC dumps, all 10 lose simultaneously. True diversification requires low correlation.
Check Correlation:
- • BTC and ETH: 0.8-0.9 correlation (very high - not diversified)
- • BTC and SOL: 0.6-0.7 correlation (moderate - some diversification)
- • Trend following and mean reversion on same asset: 0.2-0.4 (low - good)
- • BTC strategies and forex strategies: 0.1-0.3 (low - excellent diversification)
Psychology of Risk
Mistake: Revenge Trading
After a loss, increasing position size to "win it back quickly." This is how accounts blow up.
Solution: Stick to your risk rules no matter what. Take a break after 3 consecutive losses.
Mistake: Overconfidence After Wins
Increasing risk after a winning streak because you feel "hot." Mean reversion applies to traders too - wins revert to normal.
Solution: Risk rules don't change based on recent results. Stick to 1-2% always.
Mistake: Moving Stop Loss
Price approaches your stop so you move it further away "to give it more room." Destroys risk management.
Solution: Stops are sacred. Set them based on logic before entry and never touch them.
Mistake: Overleveraging
Using 10x leverage to make bigger gains. Magnifies losses equally and increases liquidation risk.
Solution: Stick to 1x leverage (spot trading) until you're consistently profitable for 6+ months. Leverage is for experts only.
Risk Management Checklist
Before Every Trade, Verify:
- ☐ Risk is 1-2% of current account balance
- ☐ Stop loss is set before entry
- ☐ Position size calculated based on stop distance
- ☐ Total portfolio heat (all positions) is <8%
- ☐ New position doesn't add excessive correlation
- ☐ Not revenge trading or emotionally compromised
- ☐ Account not currently in >20% drawdown
- ☐ Risk/reward ratio is >1.5:1