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In this lesson, you’ll learn the fundamental principles of risk management that separate successful traders from those who lose their capital. Understanding how to protect your trading capital is essential before implementing any trading strategy, and we’ll walk you through the core concepts that professional traders use to manage their exposure.
Risk management is built upon three fundamental principles. First is equity capital, which refers to the portion of your money allocated for trading that you can afford to lose without impacting your daily life. This risk capital must be completely separate from essential funds for living expenses like rent and food. The second principle is risk per trade, which determines the amount of money you’re willing to risk on each individual trade based on your risk tolerance and confidence level. Finally, maximum exposure represents the total amount of money you’re willing to risk at any given time across all your active trades, preventing catastrophic losses during negative market movements.
A widely used rule of thumb is to risk 1% to 2% of your capital on each trade. For instance, if your trading capital is $10,000, you should be willing to risk between $100 and $200 per trade. However, this guideline can be adjusted to suit your specific trading strategy and risk appetite. Every trade should include a clear execution plan with a stop loss (the maximum amount you’re willing to lose) and a take profit target (your desired profit level).
Understanding drawdown helps you assess the potential risks associated with your trading strategies. Drawdown represents the ratio between the period’s maximum value and the difference between the all time high and all time low values during that period. This is why we have developed the MenthorQ models to help investors make more informed decisions using a data driven strategy.
Video Chapters
00:00 – Introduction to risk in active investing
00:48 – The rise of retail trading and common pitfalls
02:06 – Three fundamental principles of risk management
03:51 – The 1% to 2% rule of thumb
04:32 – Stop loss and take profit levels
05:49 – Understanding drawdown
Key Takeaways
Risk management is built on three principles: equity capital, risk per trade, and maximum exposure
A widely used guideline is to risk 1% to 2% of your capital on each individual trade
Every trade should have a clear execution plan including stop loss and take profit targets
Drawdown helps you assess the potential risks associated with your trading strategies
Video Transcription
[00:00:00.05] - Speaker 1 In this lesson, we will talk about the concept of risk. Active investing offers the possibility of obtaining higher profits than passive investing. At the same time, actively investing carries higher risks. Depending on the asset we choose, the price of these assets moves and they have a certain volatility. These price movements can lead to gains and losses.
[00:00:23.13] - Speaker 1 Some assets have lower risks than others. For example, bonds are less volatile than stocks. Large cap stocks of companies like Apple or Microsoft move less than small cap companies. With the low float. With COVID 19 and the development of online trading platforms such as Robinhood, we have witnessed the entry into the markets of new participants, especially retail investors.
[00:00:48.18] - Speaker 1 Now it is very easy to create an account and start trading with a few thousand dollars. Many of these brokers also offer the possibility to use leverage. This pushes profiles of risk takers to enter the markets. We often see YouTube videos of successful traders who work two hours a day and bring home thousands of dollars. Some of these manage to bring home hundreds of thousands of dollars in a single day.
[00:01:14.08] - Speaker 1 Sounds too good to be true. The power of social media therefore pushes many of us towards the hope of easy, easy money. Unfortunately, this dream does not last long and most traders fail by losing most if not all of their capital. The reason is very simple. They do not understand the importance of risk management.
[00:01:34.11] - Speaker 1 We have seen this with the end of quantitative easing in 2021 when the Fed started raising rates. Risky assets like growth stocks and crypto failed retail investors that saw double Digits profits in 2020 lost most of their capital and exited the market. Risk management is built upon three fundamental principles. The first is equity capital. This refers to the portion of your money allocated for trading that you can afford to lose without impacting your daily life.
[00:02:06.20] - Speaker 1 It is essential to distinguish this risk capital from your essential funds for living expenses like rent and food and other necessities. For example, if you have $10,000 as risk capital, ensure that even in the event of losing this amount, your daily life will not be adversely affected. It is important to view trading capital as expendable and separate from your essential finances. Trading always carries a degree of risk and maintaining a safety net for your daily living expenses is important to ensure financial stability. Then we have the risk per trade.
[00:02:42.04] - Speaker 1 This principle involves determining the amount of money you are willing to risk on each individual trade. Your risk per trade should align with your risk tolerance and can vary based on your confidence in a particular trade. Managing your risk per trade helps control potential losses and preserves your overall capital. It involves assessing your personal risk tolerance and trading strategy. Some traders may be comfortable risking A larger percentage of their capital on a single trade, while others may prefer to be more conservative.
[00:03:15.18] - Speaker 1 Understanding and defining your risk per trade helps you make more informed decisions and avoid overexposing your capital. And finally, the maximum exposure. This represents the total amount of money you are willing to risk at any given time across all your active trades. By setting a maximum exposure, you limit the total risk taken in the market, reducing the likelihood of catastrophic losses in case of negative market movements. By capping the amount of capital at risk across all trades, you prevent over committing and maintain control over your trading activities.
[00:03:51.26] - Speaker 1 Remember, successful trading is not about pursuing high risk, high reward opportunities with all your capital. Instead, it's about consistently managing risk, protecting your capital and making well calculated trades based on a solid strategy. This is also why we have developed the menthere coup models to help investors make more informed decisions using a data driven strategy. In trading, a widely used rule of thumb Is to risk 1% to 2% of your capital on each trade. For instance, if your trading capital is $10,000, you should be willing to risk between $100 and $200 per trade.
[00:04:32.18] - Speaker 1 However, this guideline can be adjusted to suit your specific trading strategy and risk appetite. Stop loss and take profit levels are key components of risk management. To ensure proper risk management, it is essential to have a clear execution plan for each trade which includes setting a stop loss and a take profit target. The stop loss represents the maximum amount you are willing to lose on a trade, while the take profit target represents the desired profit level. The risk reward ratio, which will be covered later, helps you assess the potential gain compared to the risk taken on a trade.
[00:05:10.17] - Speaker 1 Typically, the stop level per trade can be set at 5% or 10% based based on your risk profile. For example, with a capital of $10,000 and a risk per trade of 2%, the trade size would be $200. At a risk level of 5% or 10%, the potential loss on this trade would be 10 or $20 respectively. These figures are not specific recommendations, but general guidelines used by traders and should be tailored to your individual preferences. Now it is time to understand the concept of drawdown, which represents the risk of a portfolio or asset.
[00:05:49.21] - Speaker 1 Drawdown is the ratio between the period's maximum value and the difference between the all time high and all time low values during that period. By understanding drawdown, traders can better assess the potential risks associated with their trading strategies and make informed decisions to manage risk effectively. Next, we will discuss the risk reward ratio.
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