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Understanding Risk Management

risk management

A SYSTEMATIC APPROACH TO TRADING

What is Risk Management

When we consider the words Risk Management, we tend to think of it as managing your risk. However, this definition is misleading. In fact, at the Income Option, we don’t consider Risk Management as a process, but rather a system. Here’s how it works.

As you know, we consider trading a business, and like every well-run business, trading also has systems. The systems define what comes in through the back door and what goes out through the front door. For example, Starbucks will have coffee beans, milk, and sugar coming in through the back door and brewed coffee going out through the front door.

coffee shop analogy for risk managementThis is a simplistic description, but let’s assume that coffee is the only thing Starbucks sells. In this situation, the cost of coffee, milk, and sugar are costs for the company, and the revenue from the brewed coffee it sells is revenue for the company. Now, Starbucks will be profitable if the money it receives from selling coffee is more than the costs it needs to pay for the raw material. For the moment, we are not considering fixed costs like rent, salaries, and electricity.

Just like this, the trading business also has costs and revenue. Costs are all the loss-making trades that we land up taking. As much as we would like to have all winning trades, loss-making trades are a reality of our business. And the right way to look at these trades is as costs. Likewise, revenue comes from profitable trades we take. Your trading business is profitable as long as revenue is more than costs. But, for the trading business, it gets a little complicated since the costs and revenue have not been defined. This is where risk management comes in. The risk management system of your trading business will define, monitor, and control your costs and revenue. Let’s see how that works.

Firstly, to define our costs, we have to make sure that our per-trade risk is limited. This means, that every time we make a loss, that loss is pre-defined and never exceeds a certain amount. This is also known as the 1% rule. Typically, we will limit our loss to 1% of our trading capital. So, if we have a trading capital of one lakh, our per trade risk will be limited to 1% x 1 lakh or 1,000 rupees. Now, we can keep our loss to this level in two ways. We can buy as many units of the stock as we can with the amount of capital we have and set our stop-loss to the point where our loss is equal to 1,000 rupees. Alternatively, we can set our stop-loss to the point on the chart where it makes strategic sense to get out and control the number of units we buy. The choice will depend on what trading strategy you use, however, for directional trading, professional traders will always use the second system.

As professional traders, we decide both our entry point and exit points (stop-loss and profit level) during our analysis of the charts. Once these are set, we work out the number of units we can buy. For example, if we are looking at trading the JSW Steel Stock and find strong buying levels at 655. At the same time, we also see that this buying level ends around 645. We will set our entry point at 655 and our stop at or slightly below 645. This means our per unit risk will be 10 rupees. So, to get a max loss of 1,000 rupees we can buy 1,000 / 10 or 100 units. This will ensure that our loss is set to 1,000 rupees.

Similarly, we will look for the best level to sell at or above our entry point. Let’s say in the current example, this selling level starts at a price of 695. So the estimated profit is 695 – 655 or 40 rupees. When we divide the max profit of 40 by the max loss of 10 rupees, we get a risk-to-reward ratio of 1:4 (1 is to 4).

Let’s assume we have a success ratio of 60% and take 20 trades in a month. This all comes together in our risk management system, which will look something like this:

  • Capital: 1,00,000
  • Risk per trade @ 1%: 1,000
  • Minimum risk-to-reward ratio: 1:4
  • Number of trades in a month: 20
  • Success Ratio: 60%
  • Revenue (profitable trades): 12 trades (60% of 20) x 4 x 1,000 = INR 48,000
  • Cost (loss-making trades): 8 trades (40% of 20) x 1,000 = INR 8,000
  • Profit for the month: 48,000 – 8,000 = INR 40,000 (40% RoI)

As you can see, the trick here is to define the number of units for a given trade by dividing the per-risk trade you have decided on by the difference between your entry point and stop loss. Not by dividing your capital by the price of the stock.

How does Risk Management create consistency?

But how does this create consistency? Professional traders don’t look at trading as a business of gains and losses where market analysis makes or breaks your business. They look at trading as a business of probabilities. Just like the insurance industry or the casino industry. Let’s take a closer look at the insurance industry to better understand how we create consistent profits in the trading business.

Insurance companies operate by providing financial protection to individuals and businesses against potential losses due to unexpected events or risks. Customers pay premiums to the insurance company, which pools the funds to create a reserve. The company uses this reserve to pay out claims to policyholders who experience losses covered by their policies. Insurance companies use actuarial science to determine the likelihood of a particular event occurring and set premiums accordingly.

Essentially what actuarial science is trying to do is set a probability of a particular event happening. For example, in the case of fire insurance, the probability of the insured building catching fire. Just like we use our testing and monitoring systems to set the probability of success in our trading business.

Let’s say they define this probability as 1%. Now, let’s assume that the building is worth 50 lakh rupees and the insurance premium charged by the insurance company is 1 lakh rupees.

In terms of a risk management system, this means that 99% of the time the insurance company is going to keep the premium i.e. make 1,00,000 rupees and 1% of the time they will need to pay 50 lakh rupees. If they have only one customer, in case the building catches fire, the insurance company is going to go bust. Since the money it would have earned from the premium will unlikely cover the payout.

So what the insurance company does is have a lot of customers. Let’s say that they get 1,000 such customers, each paying 1,00,000 in premium and the insured buildings are worth 50 lakhs each. According to the probability of catching fire, 1% or 10 of these buildings can catch fire. So the company will have to pay out 10 x 50 lakhs or 5 crores. But they would have collected 1,000 x 1,00,000 = 10 crores in premium.

Isn’t this just like a trading business? If I bet my entire capital on one trade and that trade makes a loss, my business shuts down. But if I divide my risk across many trades, work out the probabilities, and keep my risk per trade constant, I can be profitable overall.

Number of customers Number of trades
Premium Profit per trade
Pay-out Loss per trade
Probability of eventSuccess Ratio

But insurance companies are some of the most profitable companies in the world. This is because they know that the system works. They know that if they keep adding as many customers as they can and make sure the probabilities and payouts are under control, they are going to make money.

That’s how it works in the business of trading as well. To be consistently profitable, we have to trust the system and make sure we keep our risks per trade constant and watch those success and risk-reward ratios.

When should you design your Risk Management system?

The best time to design your risk management system is before you start investing in the market. This is because risk management is an essential component of any investment strategy, and it’s important to have a plan in place to manage risks before you begin to take on market risk.

By designing your risk management system before you invest, you can ensure that your investment strategy aligns with your investment goals and risk tolerance. This will allow you to develop a risk management plan that is tailored to your specific needs and preferences.

To know more about how to set up a professional risk management system, join a trial of our Income Systems program. In the program, I take you through the process of setting up your trading business while sharing my trades with you so that you can make money right from the start.

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