Risk management, we talk about it all the time in the live signal rooms. It is one of, if not the, most crucial parts of trading. You can have all the best trade ideas in the world, but if you cannot effectively manage your risk, you are setting yourself up for failure.
It’s important to note that risk management will differ depending on the type of underlying you are trading. The thing to focus on is DOLLARS AT RISK. Let’s take the example of an oil futures trader. That risk is determined by the amount of ticks one is will to make or lose. For a standard crude oil contract (CL) the tick value is $10. This is because the contract represents 1,000 barrels of oil, and 1,000 barrels multiplied by the $0.01 tick size results in $10. That means for each contract, a one tick movement will result in a profit or loss of $10. So, one way to approach risk management in this case is to say I am targeting a $0.05 move on my winners and I will stop myself out if I lose $0.03. Then it’s just a matter of risk tolerance to determine how many contracts you want to trade. But then let’s look at what an options trader may face. Let’s use the example of the purchase of a debit call spread. Remember, it’s DOLLARS AT RISK. So, the amount of contracts one should trade is determined by the amount of the debit. You don’t trade a static amount of contracts, you trade a static amount of risk. So, if you were looking at two different spreads and one is trading $1.00 and the other is trading $0.50 you can trade twice as many of the $0.50 spread and then base your targets and stops based on your own risk tolerance.
Click the video above (from Khan Academy) to learn more.