Creating a Risk Management System

A complete risk management system protects your capital systematically. It should operate automatically, regardless of how you feel about any particular trade. [DEFINITION] Risk Management System: A comprehensive set of rules and processes designed to identify, assess, and limit potential losses across all trading activities. ### Components of a Complete System **1. Per-Trade Risk:** Maximum risk on any single trade. - Typically 1-2% of account - Never more than 3% under any circumstances **2. Daily Risk Limit:** Maximum loss per day. - Typically 3-5% of account - Stop trading after hitting limit **3. Weekly/Monthly Risk Limit:** Maximum loss per period. - Weekly: 5-10% - Monthly: 10-20% - Reduce size or stop trading when hit **4. Maximum Drawdown Limit:** Account decline that triggers evaluation. - At 20% drawdown: Reduce position sizes by half - At 30% drawdown: Stop trading, evaluate system [KEY] Multiple layers of protection ensure no single mistake destroys your account. ### Building Your System **Step 1: Define your risk units** [EXAMPLE] $100,000 account - 1R = 1% = $1,000 per trade - Max 5 positions = 5R = $5,000 max open risk - Daily limit = 3R = $3,000 **Step 2: Set position sizing rules** - Size every trade to risk exactly 1R - Use ATR or support-based stops **Step 3: Create circuit breakers** - 3 losses in a row = stop for the day - 5% weekly loss = half size for remainder of week - Monthly loss = pause and review ### Correlation Risk [WARNING] Five 1% positions can become 5% risk if they're all correlated. **Manage correlation:** - Maximum 2-3 positions in same sector - Maximum 3-4 long positions in bull markets - Consider having some uncorrelated positions [EXAMPLE] You have 5 positions: Apple, Microsoft, Google, Amazon, NVIDIA. All tech, all correlated. A tech sector selloff hits all 5 simultaneously. Your "5% risk" becomes realized as 20% loss. Solution: Diversify across sectors. ### Scaling Rules **Reduce size when:** - Losing streak occurs - Volatility increases - Drawdown exceeds threshold - Uncertainty is high **Increase size when:** - Winning streak continues - Volatility decreases - Confidence (based on results, not feelings) is high [FORMULA] Position Size = Base Size × Win Streak Multiplier (optional) ### Creating Your Risk Playbook Document rules for: 1. Normal market conditions 2. High volatility conditions 3. After losing streaks 4. After winning streaks 5. Around major events (earnings, Fed) [TIP] Write these rules when you're calm and rational. Follow them when you're emotional and irrational. ### Weekly Risk Review Every week, review: - Total P&L (in R-multiples) - Win rate - Average winner vs. average loser - Largest win and loss - Rule violations [EXERCISE] Design a risk management system for a $50,000 account. Specify: risk per trade, max positions, daily loss limit, weekly loss limit, and what you'll do at 15% drawdown. |ANSWER| Example: Risk per trade: 1% ($500). Max positions: 5 ($2,500 max risk). Daily loss limit: 2% ($1,000). Weekly loss limit: 5% ($2,500). At 15% drawdown ($7,500 loss): Cut position size to 0.5%, maximum 3 positions, review all trades to identify problems before resuming normal trading. [SCENARIO] You've had a great month—up 15%. You feel invincible and want to increase position sizes to capitalize on your "hot streak." Is this a good idea? Proceed carefully. While it's reasonable to slightly increase size after sustained success (your account is larger), dramatic increases driven by feeling "hot" are dangerous. The market doesn't care about your streak. Instead of doubling size, perhaps increase 25-50%. And have rules for reducing back if the streak ends. Confidence built on recent success often precedes humbling losses.