Risk Management 5

So far we have completed the way I assess position sizing. The next step is to manage the trade.

The first step is to identify the entry, initial stop and core profit exit- this is function of your plan.

The next step is to assess the trade’s risk-reward. Because I use the Rule of Three, I assess the risk-reward based on the core profit contract (usually the opposite Primary Zone) and average profit. The risk-reward must be at least 1:2 (based on the structural exit) and 1:1 (based risk compared to historical average profit).

Let’s look at an example.

Figure 1 shows the 5-d and 18-d swings in the ES. Let’s assume we are trading the 5-d and that the average profit per trade in the ES is 80 points. In Figure 1, the risk to average profit would be 1:2.2. Figure 1 shows that the structural risk-reward is 1:3.2

This trade has a qualified risk-reward.

FIGURE 1 ES Risk:Reward

So, before I even enter a trade, I first assess whether or not the risk is worth trading.

Once we are in a trade, we need to manage our risk.

The Rule of Three states that we cover the first 1/3 when the profits cover our risk on the remaining contracts. Unlike the core profit exit, this is a guideline rather than a fixed exit.

Figure 1 shows that the risk on two contracts is 66 points. Our entry was 1277; so, we’d exit the 1st third at (1277 + 66) 1343. But if we look at Figure 1, we see that the Point of Control is coming in at 1339.98.

We know that the 18-d is in a downtrend, as is the 13-w. So, we are trading a contra-trend move in the higher timeframes. In this situation, I’d look to exit before 1339.98, say 1335 to 1337. I then move my initial stop on the 2nd third to allow for the lower exit. So, if my exit is 1335, there is a difference of 5 points. I’d move my 2nd third’s stop to 1247 (originally at 1242; plus 5 = 1247). This way if stopped out, I’d preserve my capital.

Once the market has a bar’s range above the top of the Value Area, 1386 (i.e. a Whole Point Count of 1 above 1386), I move the stop on the 2nd contract to under the low of the Value Area. In the case of Figure 1, this area is between 1306 and 1275.

Once I exit the 2nd contract at the Primary Sell Zone, I’d bring the stop on the 3rd contract to breakeven.

On a breakout, to manage the 3rd contract, I use a trailing stop using:

1. Swing lows or deemed swing lows and
2. Bring the stops closer as the impulse move’s magnitudes moves to mean +3 standard deviations. At this target, I tend to bring the stops no farther away than breach of the 3-d low.

Of course if I have a Change in Trend Pattern, I’d exit on that even if the trailing stop is not hit.
There you have it.

We have covered the ground from Money Management to Trade Management: the two components of Risk Management. Happy trading guys and gals.

4 thoughts on “Risk Management 5”

1. Ray

When trading intra-day, I reckon a risk reward ratio of 1:1 is good to take a trade whereas for swing trades, at least 1:2 if not 1:3 ideally.

Sometimes, if I find my entry is wrong, I exit without delay with no thought for risk reward.

BTW here is a cross ref to Traderfeed :

By Dr Brett:
* Risk Management and Position Sizing – Ray Barros has been on a tear, with excellent posts on these topics. Great ideas from an experienced trader and mentor of traders.

2. MEMO

Following my recent post that a vacant seat was available for the August SMU seminar in Singapore, this seat is now filled.

However, if any one is keen to attend, do contact me to put you on the WaitList so that in the event of a cancellation due to valid reasons, the seat could be released, on a first come first serve basis.

Thank you for the overwhelming support to those who have registered well in advance.

3. ECONOMIC CALENDAR

NON-FARM PAYROLLS
# Source: Bureau of Labor Statistics, U.S. Department of Labor.
# Release Time: First Friday of the month at 8:30 ET for the prior month

With any important economic release, one needs to follow a Best Practice, and I would like to share two Best Practices at: