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The Trading Plan – 4. Risk and Money Management

December 14, 2011
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The risk management component of the Trading Plan deals with the various risks in the market and money management deals with how you will manage those risks. Risk and money management are the key components of any Trading Plan as it is the preservation and trade management of your capital that will allow you to achieve or fall short of your mission and your goals. These two areas of the Trading Plan will be the biggest determinants of the size of returns and drawdowns, once an edge is in place as per the previous section of the Trading Plan.

If one manages to destroy their trading capital then there isn’t much hope of achieving the stated aims! If however, you have strict and well documented rules for the management of your risk capital (i.e. your money), then not only can you engage the market with consistency, commitment and confidence free of doubt, hesitation and reseravtions, but you can also go a long way to ensuring that you will achieve longevity in the market without being tormented by the fear and greed monsters.

These two facets of the Trading Plan determine how much of your trading capital to deploy on any given trade of strategy at any given time depending on certain pre-defined criteria to do with any number of risk items including but not limited to:

    • the overall market,
    • particular sector risk, if applicable,
    • inter-related markets,
    • individual trade risk,
    • portfolio risk as determined by portfolio run-up and or drawdown,
    • diversification levels across systems and / or market sectors,
    • market timing, i.e. level of overbought or oversold, and
    • trading environment risks, such as computer failure, internet failure, broker failure etc.

To help determine how much risk you are prepared to take you need to ask yourself the following questions:

      • What are the various risks that could affect my portfolio? Many of these may be totally unknown to us, and may not even be able to be known because they may never have occurred before or entered our conscious thoughts. The World Trade Centre attacks of September 11, 2001 fall into this category as does the Japanese tsunami of March 2011. What is important is to recognise that events such as this can happen, and we need to document what we will do if such an event occurs.
      • How do I determine all the risks that could affect my portfolio? This may be even more difficult given that we may not even know what some of these risks may be but stating how you will go about answering this question will ensure that you step into a process to find the answers.
      • How often do I assess this risk (daily, weekly, monthly, never – buy and holders are in the never category)?
      • How do I deal with assessed risk in any given moment?
      • How much money am I prepared to risk of my overall portfolio?
      • How much money am I prepared to allocate to individual trades?
      • How much money am I prepared to risk on individual trades?
      • How and at which point will I take profit from open trades and will I close the whole trade or only a portion of it?
      • How and when will I exit losing trades?
      • Am I going to trade with leverage and if so how much and under what defined circumstances will I increase or decrease leverage and to what limit?
      • Under what circumstances will I reduce exposure to the market or increase exposure to the market?
      • What criteria need to be in place to step aside from the market altogether and go 100% into cash?
      • What criteria need to be in place to re-enter the market and with how much capital? You need to define when you will have your money in the market and when you’ll have it out. There may be times when you will have your money in cash rather than in the market, and other times when you will be fully invested in the market or markets you are trading. The criteria for these periods need to be clearly defined.
      • Does this all fit within my risk profile as stated in the Goals and Objectives Statement of the Trading Plan?

These and more questions need to be answered in the Trading Plan. Not having answers to these important questions can lead to indecision and hesitation in the heat of the moment in the market which will lead to trading mistakes. Most mistakes are made when under pressure and pressure is most often present when the market is going against your positions and the risks that need to be dealt with are all coming to the fore.

Do the preparation before you get into such circumstances. The more unambiguous your criteria are in answer to the questions listed above the less indecision there will be, the more consistent and objective you will become and the more successful a trader you will become.

Can’t wait until next week? Read the next blog in The Trading Plan series:
The Trading Plan – 5. Process Management

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