Risk Management

Nearly all of the traders who are following my guided trading threads have
  one major issue... They have all lost lots of money. Why does this happen?
  Because traders jump into the ring, without any preparation or plans.


What are your risking normally - its your hard earned capital. If you trade
  without any basic money management or risk management plan, you will surely
lose  all your capital.


Here is a framework to set things in order, which can save you a lot of
  tension, emotional drainage and fear of the market.


Fundamental - DO NOT TRADE IF YOU DONT HAVE FOLLOWING TWO POINTS MANAGED:


1. A trading system (even if these are tips) which doesnt generate better
  than 60% winning trades.(and you will see why shortly).


2. You dont have a written money management plan, which you use,
  everyday.


Here is an example of the factors involved in money management. If you have a
  capital of 100000, decide how much you can risk to lose in a day,week and a
  month.
Example, we say 0.5%-2% per day. This translates upto 40% per month,
  which is unacceptable, so you have a weekly and monthly cap as well.
Say 5%
  for the week
and 10% for the month.



So to avoid our capital disappearing into smoke, the first rules for
  trading that evolve are:
If any day our loss exceeds 2%, (Rs 2000) stop we
  trading for the rest of the day.
Any week, our loss exceeds 5% (Rs 5000)
  cumulative, stop trading for the rest of the week.
Any month, your loss
  exceeds 10%, (Rs 10000) stop trading further.
At each of the stops, incase
  these are hit, we should review the trading methodology.


Unless our trading system delivers 60-70% winning trades on a consistent
  basis, first on paper trades and then in the real trading environment, we dont
  trade again. Money that you dont trade is money saved.
So on every day/week
  and month, use the win %age and the loss amounts as barriers for any further
  trades. And if you dont cross them, step back, review and fix the basic issues.
  If you do cross, the barriers, you are cruising to success.


If the win trade ratio of your trading system is not >60% the absolute
  minimum, then your trading method is faulty and you are gambling. Review the
  method and fix it first, as suggested above.



Now, a little deeper into the daily loss of 0.5-2%. If your risk is say 2
  % of capital in a day. Say for Nifty futures margin is Rs 40000. The risk
amount  per day is 2% or Rs 800. So if you do 3 trades in Nifty in a day or lets
say 4,  then you cannot risk more than Rs. 200 loss per trade or 4 points. Your
reward  or profit per trade needs to be at least 2:1 times this risk or Rs 400
so that  even if your success ratio is 50%, 2 winning and 2 losing trades you
lose Rs 200  per trade = Rs 400 total, and gain Rs 400 per trade = Rs 800, with
a net gain of  Rs 400, you still are a winner. Target therefore for higher risk
reward ratios  of 3:1, if you can.


See the linkage of the winning trade %age of greater than 60% instead of 50%
  above and a modest risk reward ratio of 2:1. If these are met consistently, you
  are winning consistently and making money.


So here are your trading rules:


Decide your daily,weekly and monthly loss risk %ages of your capital.


Example Capital 100000, risk %age per day 2%= Rs 2000, Weekly 8% = Rs 8000
  and Monthly 15% = Rs 15000.


This means you cannot lose more than Rs 2000 in all transactions per day, Rs
  8000 in all transactions for the week and Rs 15000 for all transactions for the
  month.


Within each day, week and month, follow the following methodology.


End of each day/week/month:


Compute the trade win ratio = Your trades that were proftable after
  brokerage/(total trades that you did).


So if you did 8 trades in a day and 5 were profitable, your trade win ratio =
  5/8 = 61% approx.


Analyse your winning trades. If your daily risk capital is Rs 2000 and if you
  allocated Rs 1600 to the risk for your trades, say at Rs 200 for each trade (it
  can vary for different scrips), did you win 2:1 = Rs 1600*2 = Rs 3200? The
  individual trades ratios are unimportant, so long as the focus is clear. If the
  profit number is not Rs 3200, review what went wrong, and confirm whether it
was  a major or minor issue with your system.


Now at the end of the day/week/month, do the above nos tie up?


Win ratio consistently > 60%


Profit for day > allocated and utilised risk capital - if it was Rs 1600
  for a particular day - your profit must be Rs 3200.


Profit for week > allocated and utilised risk capital used that week. Say
  Rs 4000 - Your weeks profit must be Rs 8000 at least.


Profit for month > Allocated and utilised risk capital say Rs 12000 - Your
  profits for the month must be Rs 24000 or more..


Stop, review and fix issues, whenever, these benchmarks are not achieved.


Paper trade when you strart trading again, to ensure that you are on the
  right track. You NEVER lost money by not trading