Six Keys To Effective Risk Management

Six keys to effective risk management

1. It is not just that risk is hard to understand–some risks may be impossible to understand. Your risk management plan has to leave room for the unknown and the unknowable. This is why advice from great traders always includes a reminder to “stay humble” or to avoid hubris. There’s a lot you don’t know in the market, but there’s also a lot you cannot possibly know. And, in markets, what you don’t know certainly can hurt you.

2. Think about the extremes. Understand the most extreme events that have happened in your market, then look backward and out: look at related markets and go back in history. What is most extreme thing that has ever happened, in the entire recorded history of markets, in markets that might be like yours? Once you understand this, realize that more extreme events lie in the future. Ask the questions: What would happen if you had a position on? How bad could it be? Then, assume that your answers, even with a healthy dose of “paranoia” built in, vastly understate the risks.

3. Think about the “middles”: What are the common risks you will face in this market? What happens a few times a year that could be unsettling? How can you prepare for and protect yourself against these events? Many traders only focus on the extreme risks, but a lot of trading accounts die sad deaths from a thousand cuts. Mundane risks add up, and mundane risks can take you out of the game permanently.

4. Your trading strategy is a risk. One of the biggest risks most developing traders face is that they are doing something that simply doesn’t work. To paraphrase Jack Schwager, you can’t make money without having an edge in the market, and if you don’t know what your edge is you don’t have one. How well do you know your strategy and its characteristics, and how sure are you of those numbers? The unexamined life may not be worth living–Socrates was probably right–but the unexamined trading system is certainly not worth trading!

5. You are the biggest risk. Yes, that’s right you. All of your talk of discipline, preparation, planning, all of the hours of screentime, all of the chats with trader friends–all of that isn’t worth much if you are don’t follow through and do the right thing. If you aren’t disciplined every moment of every trading day, you are not a disciplined trader. The market environment is harder than you can imagine, and it will challenge you to the very limits of human endurance. Spend a lot of time thinking about the most critical part of your trading system: you, yourself.

6. Plan for risks outside the market. Everyone, from the institutional scale to the individual trader, will have outside influences challenge their market activities. Institutionally, regulatory changes and developments in market structure can dramatically change the playing field. Your investors will make mistakes–becoming fearful and exuberant at exactly the wrong times. If you’re an individual investor, you will face outside financial stresses, personal issues, health issues, etc. All of these things will have an effect on your trading that is hard to capture in the numbers, but prudent planning will allow you to navigate these challenges.

Six keys to effective risk management was originally published on Adam H Grimes