Chapter 05

Risk Management for Traders

Most traders who fail don't lose because they picked the wrong stocks — they lose because they didn't manage risk. Risk management is the set of rules that keeps you in the game long enough for your edge to play out.

The Golden Rule: Survive First

If you lose 50% of your account, you need a 100% gain just to break even. Losses compound faster than gains. The math is brutal:

  • -10% loss: Need +11.1% to recover
  • -25% loss: Need +33.3% to recover
  • -50% loss: Need +100% to recover
  • -75% loss: Need +300% to recover
Recovery Return = 1 / (1 − Loss%) − 1. The deeper the hole, the harder it is to climb out. Preservation of capital is job #1.

Stop Losses

A stop loss is a predetermined price where you exit a losing trade. It turns a potentially unlimited loss into a controlled, planned one.

Types of stops

  • Fixed percentage stop: Exit if the position drops X% from entry. Simple but doesn't account for the stock's normal volatility.
  • ATR-based stop: Set stop at entry price minus 1.5–3× the Average True Range. Adapts to how volatile the stock actually is. A stock with $2 ATR gets a wider stop than one with $0.50 ATR.
  • Technical stop: Place stop below a key support level, trendline, or moving average. If the structure breaks, the trade thesis is invalid.
  • Trailing stop: Moves up as the price rises but never moves down. Locks in profits while giving the trade room to run.
  • Time stop: Exit if the trade hasn't moved in your favor within a set number of days. Dead money is a real cost.

Risk/Reward Ratio

Before entering any trade, calculate the ratio of potential profit to potential loss:

Risk/Reward = (Target Price − Entry Price) ÷ (Entry Price − Stop Loss)

A 2:1 risk/reward means you're targeting $2 of profit for every $1 of risk. At this ratio, you only need to win 34% of your trades to break even. Most professional traders look for 2:1 or better.

Maximum Drawdown Limits

Set hard limits on how much you're willing to lose before stepping back:

  • Daily limit: Stop trading if you lose more than 2-3% in a single day
  • Weekly limit: Reduce position sizes or pause if down 5% for the week
  • Monthly limit: If down 10% from monthly high, stop and review your strategy
  • Account limit: If total account drops 20%, halt all trading and reassess
Drawdown limits are non-negotiable. They exist to protect you from yourself during losing streaks, when emotions run highest and judgment is worst.

Understanding Value at Risk (VaR)

VaR answers a key question: “What is the most I could expect to lose on a given day under normal market conditions?”

A 95% daily VaR of $5,000 means: on 95% of trading days, you should lose less than $5,000. On the other 5% — the bad days — losses will exceed this amount.

Ways to estimate VaR:

  • Historical: Look at your actual past returns and find the 5th percentile
  • Parametric: Assume returns follow a normal distribution and use standard deviation
  • Monte Carlo: Simulate thousands of random scenarios to estimate the distribution

Correlation Risk

If all your positions move together, you don't have 10 positions — you have one big position. During market stress, correlations increase, meaning “diversified” portfolios can suddenly behave as if they're all the same trade.

Watch for hidden correlations:

  • Multiple tech stocks are all exposed to the same macro risk
  • Long oil stocks & short airlines — both tied to oil prices
  • Different currencies that are all dollar-dominated trades

Emotional Risk Management

Quant data gives you an edge, but only if you follow the rules. The biggest risk isn't the market — it's you.

  • Revenge trading: Doubling down after a loss to “win it back.” Always leads to bigger losses.
  • Overconfidence: A winning streak doesn't mean you've cracked the code. Variance works both ways.
  • FOMO: Chasing a trade that already moved. If you missed the entry, wait for the next setup.
  • Moving stops: Widening your stop to avoid taking a loss. If your stop was rational when you set it, honor it.

A Risk Management Checklist

  • Define your stop loss before entering every trade
  • Never risk more than 1-2% of your account on a single trade
  • Keep total portfolio risk (heat) under 6-10%
  • Know your risk/reward ratio — is it at least 2:1?
  • Check correlations between open positions
  • Have daily, weekly, and monthly drawdown limits
  • Keep a trade journal and review losing trades weekly
  • Never add to a losing position