How to Apply Risk Management in Short-Term Trading

Reduce Risk and Increase Profits.

As traders, your goal is simple: 

to make profits while taming the risks involved. 

Every price fluctuation can either make or break your day. Therefore, it becomes essential to understand the importance of discipline, strategy, and, above all, impeccable risk management.

In this article, we'll explore the key principles of risk management, with a special focus on short-term trading. 

Our aim? 

Not only safeguarding your capital but also furnishing you with the insight and tools for your trading journey.

Accept Reality: Acknowledge the Challenges

Before we dive into the strategies for risk management, 

Here are some heads-up first!

It's essential to confront some common misconceptions before starting trading. Many traders in the trading world tend to overestimate their abilities and underestimate the challenges ahead. Here are a few truths to remember:

• Trading is Not a Shortcut: Trading is not a get-rich-quick scheme. It's a profession that requires time, effort, and continuous learning.
• Risk is Ever-Present: The financial markets are inherently volatile. Risk is not a possibility; it's a certainty.
• Overconfidence is Dangerous: Overconfidence can lead to costly mistakes. Always approach trading with humility and a willingness to learn.
• Mobile Trading Comes with Responsibilities: Trading from your mobile device is convenient, but it doesn't exempt you from the need for proper risk management.

So, what are the Strategies for Trading Risk Management?

Effective Risk Management involves the use of the following strategies;

1. Understanding the Risk-Reward Ratios
2. Effectively employ Stop-Loss Orders
3. Using Trailing Stop-Loss Orders
   1. Place Your Stop-Loss Conservatively:
   2. Adapt to Volatility:
   3. Never Remove Stop-Loss Orders Emotionally:
   4. Avoid Revenge Trading:
4. Always Diversify
5. Use Position Sizing
6. Avoiding Overtrading
7. Using Hedging
8. Continuous Learning: The Key to Long-Term Success
9. Use Risk-Management Tools

Now, let's dive into the depths of these strategies;

1) Understanding the Risk-Reward Ratios:

Effective risk management begins with understanding the concept of risk-reward ratios. 

In simple terms, this means that for every trade you take, you should have a clear idea of how much you stand to gain in relation to how much you are willing to lose. Here's how it works:

• Define Your Risk Tolerance: Determine the maximum amount of capital you are willing to risk on a single trade. This should be a small percentage of your total trading capital. Generally speaking, traders recommend not to risk more than 2 % of your total trading capital.

For example, if you have a total trading capital of $20,000, then you can risk a maximum of 2% = $400 on a single trade.

• Set Realistic Profit Targets: Decide on a profit target for each trade. This should be at least twice as large as your potential loss (i.e., a 1:2 risk-reward ratio). For instance, if you are setting the stop loss limit of $10 on a trade (more on stop loss below) , aim for a profit of at least $20. This way, even if you have a 50% success rate, you'll still be profitable over time.

2) Effectively employ Stop-Loss Orders:

One of the fundamental tools in risk management is the stop-loss order. They act as a safety net to limit potential losses on a trade by automatically closing the position when the market moves against you. The strategy helps traders control potential losses by setting a predefined exit point. Stop Loss orders provide peace of mind by automatically closing a position if the market moves against your trade, allowing you to protect your capital and manage risk effectively.

How Stop-Loss Orders Work:

You've entered a trade, either buying or selling an asset, and you set a stop-loss order at a predetermined price level. If the market moves in the opposite direction and reaches the stop-loss price, the order is triggered, and your position is closed at that price, preventing further losses.

Example:

Let's say you bought a stock at $100 per share.If the support level of this stock is $92, you set a stop-loss order at $90. If the stock's price falls and reaches $90, the stop-loss order is executed, and your position is automatically sold, limiting your loss to $10 per share.

Point to Note:

A Stop-Loss order, though a useful risk management tool, operates as a Market order, potentially executing at unfavorable prices due to market speed and illiquidity. This can result in unexpected losses, especially in overnight gaps.

For instance, if you buy a stock at $100, set a stop-loss at $90, and the market price drops triggering the order, it may execute at a lower price, say $80, resulting in a $20 loss instead of the planned $10.

To add flexibility, a Stop-Limit order combines a stop-loss with a price limit, allowing you to set a maximum acceptable loss. However, there's a risk of non-execution, but you retain ownership of the asset, providing potential for recovery.

3) Using Trailing Stop-Loss Orders

Trailing stop-loss orders is a dynamic way to manage risk in trading. They automatically adjust as the price of an asset moves in your favor, offering a balance between locking in profits and guarding against sudden price reversals.

How Trailing Stop-Loss Works:

Imagine you've entered a trade, and the price starts moving in the direction you anticipated, allowing your position to gain value. Instead of keeping a fixed stop-loss level, which remains static, you can set a trailing stop-loss. The trailing stop-loss "trails" the price at a specified distance. If the price moves in your favor by that set distance, the trailing stop-loss moves with it. This means that if the price reverses and reaches the trailing stop-loss level, the trade is automatically closed, locking in profits.

Example:

• Let's say you're trading a stock that you bought at $50 per share.
• You set a trailing stop-loss of $2 below the current market price.
• As the stock price rises to $60, the trailing stop-loss also adjusts to $58 ($60 - $2).
• If the stock price subsequently falls and reaches $58, the trailing stop-loss is triggered, and your trade is closed.

In this way, trailing stop-loss orders help you protect your gains as the market moves in your favor.

Important factors to consider when using Stop loss or trailing stop loss orders: 

Although you can apply stop loss orders via different methods, with some being a little simple like Moving Average Stop Loss and Pivot-based stop losses, Others may be a bit advanced like AON, Bar By Bar, and ATR by ATR stop Loss.

But, In any case, there are certain points to consider before employing them.

• Place Your Stop-Loss Conservatively: When placing your stop-loss order, it's essential to be cautious. Avoid placing it too close to your entry point. If it's too close, minor price fluctuations or market noise could trigger it prematurely, resulting in unnecessary losses. Instead, take into account technical analysis and market data. Consider factors like historical price volatility, support and resistance levels, and the specific trade setup to determine a reasonable distance for your stop-loss.
• Adapt to Volatility: Market conditions can vary in terms of volatility. During highly volatile periods, such as major news announcements or events, you may need to widen your stop-loss levels. This adjustment accounts for the increased price swings that can occur in turbulent times. In such cases, Stop Losses order like ATR-based Stop Loss, can prove really handy.
• Never (ever) Remove Stop-Loss Orders Emotionally: Once you've established a stop-loss order for a trade, it's crucial to stick to it, regardless of emotional impulses, like Fear or Greed, or market sentiment. Emotional decisions, like the temptation to remove a stop-loss order because you believe the market will reverse in your favor, can lead to substantial and unexpected losses. Your stop-loss should be viewed as a predetermined safety net, and it should only be adjusted based on rational analysis and risk management principles.
• Avoid Revenge Trading: If you incur a loss, avoid the temptation to enter another trade to recover it immediately. This is revenge trading and this type of Emotional trading can lead to further losses.

4) Always Diversify!

Diversification is another critical aspect of risk management. It involves spreading your trading capital across different assets or instruments rather than putting all your money into a single trade. Diversification can reduce the impact of a single losing trade on your overall capital. However, there are certain factors to consider when adopting this strategy;

Asset Selection: When diversifying, it's essential to select a mix of assets from various categories, such as stocks, currencies, commodities, or indices. Each of these asset classes has its own risk and return characteristics. By holding different types of assets, you can offset losses in one asset class with gains in another.

For example, if you have a trading working capital of $10,000, you can allocate $4000 in stocks, $ 3,000 to currencies, $2,000 to commodities, and $1,000 to indices. Trading Management Software like AfterPullback, which supports multiple markets worldwide, including blockchain and crypto, stocks, futures, & more, can help you to diversify your investments.

Correlation Awareness: Pay attention to the correlation between the assets in your portfolio. Correlation measures how closely the price movements of two assets are related. Assets with high positive correlation tend to move in the same direction, while assets with negative or low correlation may move independently. Diversifying into assets with low or negative correlation can provide better risk mitigation. When one asset in your portfolio experiences a downturn, assets with different correlations may remain stable or appreciate, reducing the overall impact on your capital.

As an example, Take "Gold," which is traded in the commodities market and is considered a haven for investment, and the S&P 500, which is the benchmark index for the stock market. Gold and S&P have a negative or low positive correlation. When the stock market, represented by the S&P 500, performs well, gold prices may not see significant gains. Conversely, during economic uncertainty or market downturns, gold tends to rise as a safe-haven asset as investors flock to the precious metal for safety. This correlation highlights how gold can provide a counterbalance to stock market volatility in an investment portfolio, offering protection during times of market stress.

Also Read: How to Track Trading Performance in 5 Simple Steps?

5) Use Position Sizing

Position sizing is a risk management strategy in trading that involves carefully determining the size or quantity of an asset you buy or sell in a trade. The goal of position sizing is to ensure that no single trade has an outsized or disproportionate impact on your overall investment portfolio.

For Instance, Lets breakdown a Swing Trading Example;

• You have a trading account with a balance of $50,000.
• Your risk tolerance for each trade is set at 2% of your account balance.
• You are interested in trading AAPL(Apple Inc.), which is currently priced at $150 per share.
• You have identified a support level at $140 and plan to set your stop-loss just below this level.

Calculating Position Size:

1. Determine Your Risk Amount:
   • Your account balance is $50,000, and your risk tolerance is 2%.
   • 2% of $50,000 = $1,000. This is the maximum amount you're willing to risk on this trade.
2. Calculate the Risk per Share:
   • You plan to set your stop-loss below $140 at $139.50.
   • The current price of AAPL is $150.
   • Your potential risk per share = $150 (entry price) - $139.50 (stop-loss price) = $10.50 per share.
3. Determine Position Size:
   • To calculate the position size that aligns with your risk tolerance, divide your risk amount by the potential risk per share.
   • $1,000 (risk amount) / $10.50 (risk per share) = approximately 95 shares.

Position Size Decision: Based on your risk tolerance of 2% and the specific setup for AAPL, you would purchase approximately 95 shares of AAPL at the current price of $150 per share. This position size ensures that if the trade goes against you and your stop-loss is triggered, you would incur a loss of about $1,000, which is within your predetermined risk tolerance. By carefully calculating your position size in this manner, you manage your risk effectively and align your trading strategy with your financial goals and risk tolerance.

6) Avoiding Overtrading

Overtrading occurs when traders excessively engage in buying and selling within a short period. It's driven by the temptation to take too many trades, often due to impulsive decisions or excessive market activity.

Why Overtrading Is a Concern:

Overtrading can have detrimental effects on a trading account for several reasons:

• Increased Exposure: Making numerous trades exposes your capital to higher levels of risk, as each trade carries its potential for gain or loss.
• Higher Transaction Costs: Frequent trading leads to more transaction costs, including commissions and spreads, which can eat into your profits.
• Emotional Stress: Constantly monitoring and executing trades can lead to emotional stress and decision fatigue, potentially impacting your trading discipline.

7) Using Hedging

Hedging is a risk management technique employed by traders to offset potential losses in one position by creating another position that can gain value, ideally under adverse market conditions.

Why Hedging Is Useful:

Hedging serves as a safeguard against market volatility and unexpected price movements. It can be especially valuable when:

• You have an existing trade that might face potential losses.
• You want to protect your portfolio from adverse market events without entirely closing your existing positions.

Example:

• You are an investor who owns a significant number of shares in a tech company, TechCorp Inc. (TCI).
• TCI has been performing well, but you are concerned about potential market volatility and want to protect your investment from a possible downturn.

Hedging Strategy:

• You decide to use a hedging strategy by taking a short position in the technology sector ETF (Exchange-Traded Fund), which tracks the performance of multiple tech companies in the market.
• By shorting the tech sector ETF, you are betting that the technology sector, as a whole, will decline in value.

How Hedging Works:

• If the broader technology sector experiences a downturn, your short position in the tech sector ETF will likely increase in value.
• The gains from your short ETF position can offset the potential losses in your TCI stock holdings.

Outcome:

• If the technology sector experiences a downturn, your TCI stock holdings may decrease in value, but the gains from your short ETF position can help compensate for those losses.
• Conversely, if the technology sector continues to perform well, your TCI stock holdings may benefit, and your overall portfolio's gains mitigate any losses from the short ETF position.

In this specific example, using a hedging strategy involving a short position in a tech sector ETF allows you to protect your investment in TechCorp Inc. from potential market volatility and adverse sector-specific movements while still participating in the market's overall performance.

8) Continuous Learning: The Key to Long-Term Success

As a trader, it's crucial to remember that trading is a continuous learning process. Markets evolve, and strategies that worked yesterday may not work tomorrow. Here are some tips for ongoing improvement:

• Keep a Trading Journal: Record every trade you make, including your thoughts, strategies, and emotions. and yes, Writing about your emotional state is necessary to avoid psychological pitfalls. Analyze your journal regularly to learn from your successes and failures. The Trading Journal of Afterpullback is an excellent resource for this.
• Stay Informed: Stay updated with market news, economic events, and global developments that can impact your trades.
• Learn from Experienced Traders: Seek guidance from experienced traders, and consider mentorship or trading courses to accelerate your learning curve.

9) Use Risk-Management Tools

Risk-management tools are features provided by your trading platform or broker to help protect your positions from unexpected and extreme price movements. These tools are valuable in volatile markets or situations where you want to limit potential losses.

At AfterPullback, we understand that establishing your trading edge is essential for your success. Our core features are designed to help you develop and maintain a foundation for your trading edge for effective and profitable trading. The most prominent of these tools are:

1. Backtests: The Strategy Backtester is an advanced trading strategy testing tool that helps traders design and validate their trading strategies. With this tool, traders can accurately backtest their strategies and make sure they are working with profitable strategies even before they enter the market.
2. Scanner: By using the AfterPullback scanner feature, you can Leverage the power of AI to detect valuable opportunities and gain the most out of the markets.
3. Signals: By using this Signals feature on AfterPullback, you can automate your trading workflow with AI-powered trading signals to execute trades automatically.
4. Journal: You can Record your trades and performance to improve your trading with AfterPullback’s Trading Journal.

Conclusion

Short-term trading is a thrilling journey that can offer significant rewards, but it comes with its fair share of challenges and risks. By applying effective risk management techniques, you can increase your chances of success in the world of trading.

Remember that trading is a profession, not a game of chance. With the right mindset, knowledge, and discipline, you can transform your early-stage excitement into a sustainable and profitable trading career.

Trade Smarter!