Each time I hear a day trader use the words risk management I can’t help but question their choice of words.

When you’re buying and selling financial instruments with the aim of profiting from short-term, intra-day price fluctuations, most people would categorize you as a gambler. Given the fast-paced and high-risk nature of day trading, you might think effective “risk management” could protect your capital and minimize potential losses.

So what the hell are traders referring to when they say “risk management”? I’m glad you asked. Here’s the sophisticated run down:

1. Position Sizing: Determine the size of each trade in relation to your overall capital. This ensures that no single trade can wipe out a significant portion of your account. Common strategies include risking a small percentage of your trading capital (e.g., 1-2%) per trade or using a fixed dollar amount for each trade.

2. Stop Loss Orders: Use stop loss orders to limit potential losses on each trade. A stop loss order specifies a price at which you’ll exit a trade if the market moves against you. This helps you cut your losses and prevents you from holding losing positions for too long.

3. Take Profit Orders: Set take profit orders to lock in profits when a trade moves in your favor. This helps you capitalize on favorable price movements and prevents you from getting too greedy, which can lead to giving back profits.

4. Risk-Reward Ratio: Consider the risk-reward ratio for each trade. It’s a measure of the potential reward (profit) relative to the potential risk (loss). Many day traders aim for a positive risk-reward ratio, such as 2:1, which means that for every dollar you’re willing to risk, you aim to make at least two dollars in profit.

5. Diversification: Avoid over-concentration in a single stock or asset. Diversifying your trades across different assets or markets can help spread risk and reduce the impact of a single loss.

6. Trading Plan: Create a trading plan that outlines your trading strategy, risk tolerance, and rules for entering and exiting trades. Stick to your plan and avoid impulsive decisions based on emotions (you can even place your orders pre-market and check the result post-market).

7. Risk Tolerance: Understand your risk tolerance and only take trades that align with your comfort level. Some traders are comfortable with higher risk, while others prefer more conservative approaches.

8. Capital Preservation: Prioritize the preservation of your trading capital over aggressive profit-seeking. Avoid the temptation to chase after big gains that could potentially lead to large losses.

9. Continuous Monitoring: Continuously monitor your open positions and the market conditions. Be prepared to adjust or exit a trade if the market moves against you or if your predetermined risk levels are reached.

10. Record Keeping: Maintain a trading journal to review your trades and learn from both successful and unsuccessful trades. Analyzing past trades can help you refine your risk management strategy over time.

Effective risk management is crucial for day traders to survive and thrive in the highly volatile and unpredictable world of day trading. It helps protect your capital, reduce emotional stress, and increase the odds of long-term success.

No, But Really… Is The Above Risk Management?

The ten points above could be the guidelines that come with the pension payments to the retirees living on the Las Vegas strip. The goal is to make your money last so you still have some savings left to pay for your funeral.

I can’t help but think about a poker player and his (or her) approach to the ten points above:

1.  Use really small bets on the highest minimum bet poker table so you can continue to enjoy the daily free umbrella drinks.

2. Be prepare to fold and swallow your pride when certain players go all-in.

3. On days you win, leave early so you can join the bingo evenings across the street.

4. If you play Black Jack, then split your hand when appropriate.

5. Play in different casinos and different games.

6. Start at the bar and write down your do’s and don’t’s for the evening on a napkin.

7. Stop playing if sweat from your forehead drips on the cards.

8. Good luck with avoiding temptation in Las Vegas. Stick to mocktails, I guess.

9. In case a distractingly attractive woman makes eye contact, you’re probably winning – so run!

10. The next morning you will inevitably be recounting all the money you lost.

The saying “diversification never made anyone rich” comes to mind. You can establish risk management rules to ensure that you don’t lose all your money on the same day. Sounds quite obvious, right? But fancy terminology and financial jargon won’t guarantee monetary success. A lot of money managers and bankers will convince their clients of their skill to provide risk-adjusted profitability by using specific metrics.

Instead of talking about Risk Management, pay attention to a day trader that mentions one of these metrics for risk-adjusted returns:

1. Sharpe Ratio: The Sharpe Ratio measures the excess return of an investment (or a portfolio) over the risk-free rate (typically a government bond) per unit of risk (usually standard deviation of returns). It quantifies how much return you’re getting for each unit of risk taken. A higher Sharpe Ratio indicates better risk-adjusted performance.

   Sharpe Ratio = (Return of the Investment – Risk-Free Rate) / Standard Deviation of the Investment

2. Sortino Ratio: The Sortino Ratio is similar to the Sharpe Ratio but focuses on downside risk. It calculates the return per unit of downside risk (standard deviation of negative returns). This ratio is often preferred by investors who are more concerned about minimizing losses.

   Sortino Ratio = (Return of the Investment – Risk-Free Rate) / Standard Deviation of Negative Returns

3. Treynor Ratio: The Treynor Ratio evaluates the excess return of an investment in relation to its systematic risk, often measured by beta. It’s especially useful for evaluating investments in the context of a diversified portfolio. A higher Treynor Ratio indicates better risk-adjusted performance.

   Treynor Ratio = (Return of the Investment – Risk-Free Rate) / Beta of the Investment

4. Information Ratio: The Information Ratio measures the risk-adjusted return of an investment relative to a benchmark index. It assesses whether a portfolio manager’s active management is adding value relative to the chosen benchmark. A higher Information Ratio indicates better performance relative to the benchmark.

   Information Ratio = (Active Return – Benchmark Return) / Tracking Error

5. Calmar Ratio: The Calmar Ratio assesses the risk-adjusted performance of an investment by comparing its average annual return to its maximum drawdown (the largest peak-to-trough loss). This ratio focuses on risk mitigation during adverse market conditions.

   Calmar Ratio = Average Annual Return / Maximum Drawdown

6. Ulcer Index: The Ulcer Index measures the depth and duration of drawdowns or losses in an investment or portfolio. It provides a more comprehensive view of risk by considering both the extent and length of periods of underperformance.

   Ulcer Index = Square Root of [(1/n) * Σ (drawdown)^2]

Suddenly, when hearing these metrics, I no longer think about Las Vegas.  I think about portfolio management.

So How Do I Make Money With This?

Let’s illustrate the Treynor Ratio with an example. Use this when explaining your portfolio content and performance. Your clients will love it.