You can’t avoid risk, you need to manage it

Reading time: 23-30 minutes (5.801 words)

The most important thing when trading or investing (no matter what asset) is risk management. Risk management is crucial if you want to become a successful day trader. Many traders constantly lose money because they have zero risk management:

Avoiding risk in trading does not exist. There is not a single trader in the world that trades with zero risk. There is always risk involved because you simply don’t know what will happen in the next few hours or days. So if you can’t avoid risk, you need to manage risk. If you have proper risk management you’ll never lose everything in just a few trades.

Think about a casino. A casino loses trades (games) all the time. If you trade like a casino, you’ll never lose money in the long term. Just think about it. The winrate for the casino is not 90%. If it was 90%, no customer would ever show up. Even at 60-40%, very few customers would show up.

According to the Center for Gaming Research, the casino wins about 3.5% of all hands played. An edge of just 3.5% makes many millions if millions of hands are played. There is no way the casino can lose money from playing games because they have a statistical edge. It’s simply impossible to lose in the long run if you have a statistical advantage. This same principle is used by every professional day trader.

Let’s have a look at the winrate for the casino when playing european roulette:

This one green number is key to making millions of dollars. Because the statistical chance of you winning when putting your money on either red or black is:

There are people who occasionally win some games, but in the end they always lose. Every professional day trader incorporates the same principle in their trading strategy. For example, they risk 1% to gain 2%. If their statistical chance of winning is higher than losing they will make money consistently over many years. Even if the win rate is 50/50 they still make money because they win 2% and only lose 1% each trade.

Your risk should always be 1-2% max. per trade. Meaning, you are risking 1% of your total account each trade. Let’s dive a bit deeper to understand why a risk of 1% or 2% is very important. The first thing you will encounter as a beginning day trader are losing streaks. Losing streaks happen quite often and will have a very big impact on your emotions. If you trade 100 times a year and your success rate is 50%, your chance of having 5 losing trades in a row is 81%. And if you trade 200 times, the chance is even close to 100% (96.5%).

Most people don’t realize that you need to win more % than you have lost to get break even.

Each time you lose a trade, you need to win back more % to break even. If you risk 4% each trade, you lost 20% (5 losing streak * 4%) of your account balance and you need to win back 25% to break even. You can imagine if you ramp up the risk you want to take each trade, it can quickly go the other way.

When you lose a trade, emotions will kick in. Inexperienced traders are trying to win back their lost trades. They start to take even bigger risks because they want to get back to breaking even so badly. Not realizing things only get worse. And on top of that, traders tend to not only risk more, they also tend to stay in the trade longer for bigger gains (getting greedy and overconfident or desperate).

Most traders give losses a much higher value than wins. So if you ramp up the risk and start making mistakes because you want to win back your losses, loss aversion becomes a big problem. Loss aversion is the tendency to prefer avoiding losses to acquiring equivalent gains. Trying to avoid losses can become a big problem because what will you do when you do lose a trade? Almost everyone is impacted by loss aversion. How loss aversion will impact your trading is impossible to know. The only one who knows is you. Are you panicking when markets go down? Or do you stay calm and analyze what is happening and act accordingly? It’s no secret most people panic when they see red numbers. There are many examples I discussed in my Trading and investing guide for beginners. Some examples:

So how do you counter loss aversion? It’s actually pretty simple:

Although it sounds simple, your mind will tell you different stories. It’s the same with losing weight. Losing weight is very simple: eat healthy and exercise on a consistent basis. But if you have a troubled mind that continuously tries to take short cuts and is telling you it’s ok to eat that pizza and skip some sessions in the gym because you are tired, it becomes a battle against your own mind. Likewise in trading your mind will tell you that you need to win back those losing trades for whatever reason. These thoughts will definitely happen more often if you are trading with money you need in the near future. Although it might sound obvious that you should never trade with money you can’t afford to lose, many traders are putting their entire bank account in a few trades. This can be the case when they desperately need more money so they risk their entire account and try to get huge gains to pay their debts. Not realizing they have zero experience with trading and are only making the problem even worse.

The same thing happens in quickly rising markets like cryptocurrencies. People pouring in their entire savings at once because they don't want to mis the bull run. 

Also, when traders are on a winning streak, the same thing can happen. Traders get overconfident knowing what they are doing and starting to take bigger positions because they can’t seem to lose. They stop following their own plan (if they have any) and start taking more and more risk. This will ultimately always result in trouble because you will lose sooner or later. The overconfidence from having multiple wins in a row is very common with new traders that start trading in a strong bull market. Everyone can make money if you are in a strong bull market because prices only go up. People start to think how easy trading is and then suddenly the bull market ends. Prices start to drop and people start to panic. They wait and wait, eventually selling with huge losses. Then the emotions start to kick in because they need to win back the money they lost. 

How you will react to losses is impossible to know. You have to experience it yourself. No matter how much you train it, you can still make mistakes based on emotions. Even the best traders in the world are still caught by their emotions sometimes. Key takeaway here is always stick to your plan no matter what. And never use money you need in the near future.

The best approach would be to dynamically use risk according to your trading strategy with a maximum risk ratio of 2%. As a beginner, I would not recommend to risk more than 1%-2% of your account balance per trade. 

4.1 Stop losses

A stop loss is a mechanism that can prevent you from losing too much money. Hence the name “stop loss”. Once a stop loss is triggered, a market sell order will be placed by the broker for the price you set in the stop loss. If there are buyers that are willing to buy for the price of your stop loss order then the transaction is completed and your stop loss was successful. 

If there are not enough buyers then the broker will fill any buy orders below the price you set in the stop loss. That means a stop loss is never a 100% protection against losses.

You can counter this by:

For now, be aware that stop losses are not 100% risk free. You can still lose all your money even when you are placing stop losses. Although it might not happen many times, be aware that it can happen. Another reason to only risk 1% of your capital each trade.

To counter this you can use insured stop losses. These stop losses will always hit your stop loss price target no matter what happens. But it comes with a high cost in the form of a premium fee. Because in case an insured stop loss does get hit when everything goes the wrong way the broker has lost a lot of money.

In case of low liquidity, prices can fluctuate a lot and the gap between buy and sell orders is pretty big.  Low liquidity means there are not many buyers and sellers. Meaning you can’t always buy and sell the asset for the price you want. Because a stop loss is simply a market sell order, if there are no buyers at that particular price the stop loss will trigger any price below or above your stop loss. If the gap in price is too big you can’t maintain proper risk management. That's why it's important to always look at the orderbook. Especially when you are trading low volume or unknown stocks/crypto's.

You should also be aware of stoploss slippage. Stop loss slippage is the difference between the price set at the stop loss and the price the market sell order is actually sold for. This is almost never the same so there will always be some slippage.

You should never ever trade without a stop loss. There are profitable traders that trade without stop losses but that is just not advisable. You should always minimize your chance of taking a loss. 

4.2. How to place a stop loss

Placing a stop loss is different on every exchange/broker. In tradingview you can simply set a long or short position and set a stop loss in just one click:

Once you click long or short position you can plot it on the chart:

Source: Tradingview.com

In this case, the risk reward ratio is 1:1. You risk 1$ to lose 1$. It would be advisable to use at least a risk reward ratio of 1:1 or preferably 1:2. Although this totally depends on the strategy you are using. If your account balance is $1000 and only want to risk 1% each trade then your trading position would be $10. In this example I took a long position. I expect the price to go up. If my analysis is wrong, then my stop loss will prevent further losses.

When taking a short position, you want the stop loss on top. Because if your analysis is wrong, price will go upwards:

Source: Tradingview.com

As you will learn later on, stop losses are not set in stone. Using a risk reward ratio of 1:2 is a good aim but there will be situations where you want to trade but simply can’t maintain a risk reward ratio of 1:2. You can switch to 1:1.5 or 1:3 depending on the situation.

Terms you might encounter when looking at other websites or youtube videos:

But as you can imagine, winning a few dollars per trade is not exactly something that is gonna make you rich anytime soon. Also, when trading forex (currency pairs like euro/usd) the price difference between both currencies is very small. For example, €1 = $1,27 at this time of writing (2021). That price won’t go up to $1.50 anytime soon. More like $1.273 or $1.268.

If you have €1000 and use this to buy $ you get $1270. If the price rises to $1.28 you get $1280 and gained $10. But you already used your entire account balance to make $10. You need much bigger postion sizes to make decent amounts of money without risking your entire account balance. 

But how can you trade bigger position sizes if you only have $1000? That’s where leverage comes into play.

4.3 Trading with leverage

Most common leverages based on a capital of $1000:

To visualize this process:

1. You have $1000 in your account;
2. You want to buy a security or currency for $25.000 and want to buy some other currencies for a total of $90.000;
3. You only have $1000 so you need to use leverage to get more buying power;
4. You ask your broker to leverage your captial ($1000) 100 times;
5. The broker agrees and borrows you $100.000;
6. You now have $100.000 buying power, not $100.000 capital;
7. You can spend this $100.000 buying power only on specific assets. You can't use this money for anything else;
8. You can spend this buying power untill your maintenance margin reaches zero. The maintenance margin represents the amount of equity the investor must maintain in the margin account after the purchase has been made to keep the position open.. 

Do note that your position size does not change to $100.000. You are still trading with $1000 so your position size is still $1000 but you are borrowing $100.000 to get $100.000 buying power. 

Although you are borrowing from your broker, that does not mean your broker just lets you trade and lose all that money. You have to spend that money to buy stocks or the asset you want to buy for the currency you are leveraging. The leveraged amount will not be available in your account and you can’t take it out. Meanwhile, when you are borrowing large amounts of money, the broker will always ensure that you can only lose your position size or you entire capital but never the money you borrowed. I'll get into the details of how this works later on.

In the above example you can only lose $1000 max. Unless you are trading on unregulated platforms with no negative account balance protection. In that case, your capital can go negative. This is very important to understand. If you use very high amounts of leverage and things go south, you might end up with a negative account balance which you have to pay back to your broker.

In general, if you are just starting out you should always have the buying power you want to leverage available in real cash. For example, if you want to leverage $100 100 times, you should have $100 * 100 = $10.000 in cash to back it up if things go south. Negative account balance protection is very important because that means you can never lose more than your captital in your trading account. 

The real danger of leverage is that your position or account can blow up very fast. Because when you are using leverage, you are also leveraging your pips. The higher amount of leverage you use, the smaller the price can go the wrong way before you get liquidated. For example:

You can imagine if you use 100x leverage, the price can only drop $20 and you lost your entire account.

You might be wondering why brokers can borrow you that much money. They use maintenance margin (basically your entire account balance) as insurance. Maintenance margin is the amount of money required to keep your positions or account open. If you cannot fulfill the maintenance margin requirement, you will be liquidated and your money is lost. When this happens it’s called a margin call. A margin call is simply a message from your broker to you saying your position/account will be liquidated if you do not fill up your account balance. In that case you can do two things:

1. Letting your position/account get liquidated.
2. Refill your account to keep the positions open.

If only your position or your entire account will be liquidated is based on the type of margin you use. This is called isolated margin and cross margin. I'll go in-depth about both types later on.

Once you have refilled your account with new money you created a new balance of maintenance margin. This way you can keep your positions open if you want.

You can open multiple trades while using leverage. But each time you take a leveraged trade, the amount of maintenance margin is deducted from your capital based on the percentage in the leveraged trade. For example:

Do note that this does not mean you lost that money yet. You just need that money to open a position. That position might go in the right direction so you can take out profits later on. But you need to have a certain amount of capital in your account to get into a leveraged position. 

This way the broker never has to worry about the money they “borrowed” to you. They simply close your positions before your capital reaches $0. They will margin call you and close all the positions you have before they lose any money. Although this is not 100% true. Because closing positions does also mean there has to be a buyer for that particular price. In some rare cases prices drop so fast that the broker can’t sell the position and will lose money. In those rare cases brokers might also charge you the amount of money lost. So you can get a negative account balance that you have to pay back. Be very aware of how your chosen broker is handling leverage.

To make things even more complicated, many brokers use their own version of leverage. For example, when trading on Bitmex you can only get into one leveraged position for each trading pair. And you are not borrowing any money from the broker but from someone else. For each long position there is an opposite short position. 

Bitmex is revolutionary on this part. Because you can never lose more money than the capital in your account. BitMEX employs a partial liquidation process involving automatic reduction of margin in an attempt to avoid a full liquidation of a trader’s position. If BitMEX is able to liquidate the position at better than the bankruptcy price, the additional funds will be added to the Bitmex insurance fund. If you look at the size of the insurance fund you can imagine how many traders got liquidated. But as a trader you can never lose more money than your account balance. I will say it again, it is crucially important that you check with your broker how they handle leverage and what will happen if the price drops below your account capital. In other words, is it possible to get a negative account balance?

4.3.1 Leverage in practise

Let’s have a look at a real life example:

This is the USD/JPY 5 min chart on 14 December 2021. At 08:10 UTC +1. The price retested the MA21 (white line) with a 3 line strike + engulfing candle (the green candle with 3s - Bull below it). After the closing of this candle all confluences stacked up so I entered a long position. You can see the entry, stop loss and take profit levels at the right side of the screen.

You can already notice the difference between the entry price and stop loss is only 113.706 - 113.630 = 0.076. This means if the price reaches my profit target I get 0.076 yen for each dollar in my postion. If I only have $1000 and I would use it all I would only make 76 Yen wich equals $0.66. I will need tens of thousands of dollars to make a decent profit.

I’m risking 1% to gain 2%. What is the position size and how much leverage do I need to enter this position? In this case we are trading a forex pair. The current broker I'm using has predetermined lot sizes. The minimum amount of units is a micro lot. Do you remember how many units and value per pip a micro lot is when trading JPY pairs?

Because we are trading in the JPY market, one pip will be a 0.01 move in price. To determine my position size I use a position size calculator:

Source: babypips.com

This results in a position size of ~ 30.000 units of currency. Meaning I need $30.000 to get in this position. Because one mini lot is 10.000 units of currency, three mini lots would be best. Because my capital is only $1000, I need 30x leverage to get into this position. With most forex brokers, the amount of leverage is set account wide. You can’t change your leverage per trade. You can do this when using Bitmex. But Bitmex is a cryptocurrency trading platform.

You actually only set your maximum amount of leverage once when you open your account. Or you can change it along the way. Leverage is then calculated automatically based on the amount of risk and your stop loss. The closer your stop loss to your entry price, the higher amounts of leverage will be used.

You can easily see the amount of pips from entry to stoploss in tradingview when placing a long or short trade:

You can see at the bottom that the stop loss is set at 3.8 pips. And because the risk reward ratio is exactly 2, the amount of pips from entry to take profit should be 3.8 * 2 = 7.6. As you can see, this checks out (target is 7.6). You can also calculate this by subtracting the take profit price from the entry price:

113.706 - 113.630 = 76

But because JPY markets are measured in 0,01 per pip, the last number would be a pipette (part of a pip). So 76 will be 7.6 pips. And this checks out again. Because the quote currency is JPY, the value per pip needs to be calculated by dividing one pip with the current market price * the amount of units:

You can also calculate the value per pip by dividing the risk amount ($10) with the amount of pips between entry and stop loss (3.8):

4.3.2 Isolated margin and cross margin

You can use isolated margin or cross margin. Isolated margin is tied to your current position and cross margin is tied to your account.

For example:

You take a position for $100 with 10x leverage. Meaning you are now trading with $1000. Do note your position size is still $100. You borrow $1000 from the broker to enter that position. Once the price goes in the wrong direction, the difference is first deducted from your $100 position. Once your position falls below the isolated margin level your position will be liquidated. Meaning you lost $100.

When using cross margin, your margin level is based on your entire capital. If you have a leveraged position with $100 and price goes the wrong way, your entire account balance can be used to prevent liquidation. But in the event you are liquidated, your entire capital is lost. If you still want to keep the position open, you need to refill your capital. 

This all might be a bit confusing. To recap:

Be aware that margin and leverage go hand in hand but can be used differently depending on the broker. Bitmex uses a completely new way of managing leverage and margin compared to forex brokers. 

4.3.3 Liquidation and leverage

The most important thing you should remember is that the amount of leverage determines your liquidation price. When price hits the liquidation price mark your position or account is liquidated. Meaning you lost all money in your position or your entire account (depending on the type of margin used).

The higher leverage you use, the closer the liquidation price is near the current price. Because when you use higher leverage, you have less breathing room in price fluctuations. Bitmex has a liquidation price calculator you can use to determine your liquidation price:

In this example when using 2.5 x leverage with the current trading price of $48321, the liquidation price is $34597. Meaning the price of bitcoin can drop all the way to $34.000 before your position/account get liquidated.

But when using 100 x leverage the liquidation price will be:

In this case you have less than $300 breathing room because you need to place your stop loss above the liquidation price to avoid liquidation. Using high amounts of leverage is very risky, especially for new traders. Always remember to set your stop loss above the liquidation price and never use very high amounts of leverage. Only if your position size and your analysis allows it. 

Most exchanges and brokers offer liquidation price calculators. If you use a higher amount of leverage, always calculate your liquidation price before you place any trades.

4.5. How much leverage do you need?

When using high amounts of leverage you need to set your stop loss before your liquidation price. So you should calculate how much leverage you need before you want to leverage a position. Sometimes you don’t need to use leverage at all. There are some rules to calculate the correct leverage and position size. Before we continue, here are the terms I used in the above examples:

To calculate the correct position size you need the following:

Where the position size = risk / distance to stop loss from entry in decimal.

Remember that your position size is not the same as the risk amount. Your position size does not change when you are using leverage. The only way to make more money is by trading bigger position sizes, not using higher amounts of leverage. 

You can use leverage when your calculated position size allows for a bigger position size that is larger than your current capital. That does not change your original position size, you borrow money from the broker by using leverage to get in a larger position. 

Because you need to know the risk amount and the position size to calculate leverage, you should never look at how much leverage other traders use. 100x leverage might be great for some but very bad for others. Never use the same leverage from other traders unless you know all the details explained above.

Let’s look at an example:

1. What is your capital? $1000;
2. How much risk do you want to take? 1% of capital;
3. Risk amount = 1% of $1000 = $10;
4. Determine your entry price and stop loss.

Determining your entry and stop loss has nothing to do with leverage. These positions are based on your strategy. But you need to know your entry and stop loss price in order to calculate your position size. In this case we’ll use some random entry and stop loss prices. Let's assume we’re trading bitcoin / USD.

1. Entry = $65.000
2. Stop loss = $64.000

To calculate the position size: Position size = risk / distance to stop loss from entry in decimal. You can use the tradingview measure tool to accurately measure the distance in percentage:

See the blue arrow in the chart with the distance shows as percentage (1.56%):

Source: Tradingview.com

Then we need to convert the percentage 1.56% to decimal by dividing it by 100 = 0.0156. Now we can calculate the position size:

Because your position size is smaller than your capital, you do not need any leverage. But let’s say we want to risk 3% of our capital. Then the calculation would be:

Because we only have $1000 capital we can take 2x leverage to enter with a position size of $1923. 

You can also determine your position size by calculating the difference in pips between the entry and stop loss. For example:

If you need $3 per pip, what lot size do you need to take:

One mini lot is $1 so you need three microlots to equal $3. But in this particular case if you want three mini lots that will cost you $30.000 (10.000 units * 3). But you only have a buying power of $20.000 so your broker will never allow you to make this trade. In this case, the risk of 3% is too high.

If you only risk 1% (which equals $10) you can now get in the same position only you are now risking $10 instead of $30 meaning you only need one mini lot. One mini lot will cost you $10.000 but you have $20.000 in buying power ($1000 capital * 20x leverage). Now you can take this position plus multiple other positions before you are out of buying power.

Or you can just use a position size calculator. 

The best way to remember leverage is that you never have more money than your capital. Leverage just allows you to control more money than you actually have by borrowing it from your broker or someone else. Because you are borrowing money, the opposite party must ensure that you always are able to maintain your positions. They will never allow you to lose more money equal to your capital. If that is about to happen your account will be liquidated/terminated/margin called. This way the broker basically has zero risks in borrowing you that much money. But keep in mind that your account can go negative. You are only truly protected by a negative account balance by using an account that has a zero account balance protection!

4.6 Taker and maker fees

Many brokers have taker and maker fees. Taker and makers are concepts based on the liquidity of a market. Someone who takes liquidity out of a market (order book) is called a taker. Someone who puts liquidity in the market by putting in buy orders is called a maker. To be clear, a taker always takes liquidity out of the market by filling an sell order from the order book. While a maker puts liquidity in the order book by setting a limit buy order.

Makers:

Takers:

Most of the time, maker fees are a bit lower than taker fees. But, sometimes you even get paid to become a maker. One example of positive maker rebates is Bitmex. You get paid for putting liquidity in the order books. Taker and maker fees are different between each broker and depend on the trading pair. This is important for risk management because you need to make sure you are not paying high amounts of fees.

4.7 Swap fees

Swap fees can have a negative effect on your risk management. Brokers swap positions when the day changes to a new day. They close your original position and enter a new position with exactly the same size. This swapping is called a rollover and you have to pay a fee for each swap. Basically meaning you have to pay a fee when you keep positions open overnight. Normally you won't encounter this because most day traders are using one minute to one hour time frames. But trades at the end of the day might be swapped over to the next trading day. Take a look at your preferred broker to find out the current swap fees.