Risk Management and Power of 1% Rule

Risk management has the same relation with trading as the spinal cord has with the human body. Like a human cannot survive without a spinal cord, a trader cannot survive without mastering the art of risk management.

Despite the importance of risk management, about 99 % of traders ignore risk management during trading. According to a survey, risk management and trade psychology contribute to 95% of the success in trade and the remaining 5% comes from technical analysis. This implies that traders (especially new traders) should spend most of their time mastering the art of risk management instead of focusing on fancy chart-making only.

This write-up aims to highlight the importance of risk management in trading/crypto-currency trading using some simple examples and using two hypothetical characters Mr. Raju (a new trader) and Mr. Babu (an experienced trader).

Risk Management and New Trader (Mr Raju)

Raju is a new trader. He has a 3000 USD portfolio.  He wants to trade in cryptocurrencies to make money. Also, most of the time, new traders are strongly influenced by the so-called “influencers” that have paid groups and big social media presences, sharing fancy charts and telling people to double their investment through crypto trading in no time. Raju is also strongly influenced by one such kind so-called successful trader and influencer. Raju wants to make his money doubled through crypto-trading as that’s what he has known from many online successful traders while reading their success stories.   

                Raju can draw fancy charts on Trading View and know the levels/resistance that he learned from his favourite influencer's social media platform. But he has yet to learn about risk management or trading psychology. Raju started with his Technical analysis. He found that the market favours coin “X”, and he should take his first trade. As most of the traders (and especially new traders do) jump in trade by investing all their portfolio (USD 3000) in a single currency, Raju also bought Currency X for his 3000 USD.  

In general, 10% of moments in the crypto market are “normal”. So imagine, if the market goes against his technical analysis and start falling first by only 1%, he will be not concerned as he thinks it’s not a big issue and it will go up. He is an innocent new trader who has no idea about risk management and stop-loss here. Meanwhile, the market is moving down further by 1%, so he will be now little concerned, but 2% is not a big loss (to new traders, although it is normal in crypto-trading), as the prices go down further and further, fear will come in his mind, he will be worried, that instead of increasing his portfolio, it is decreasing. For how long Raju can wait? Normally, new traders have no strong nerve, so he may be exiting the trade around at a 10% loss. This indicates that Raju has burned 10 % of his portfolio (i.e., 3000 x 0.10 = 300 USD). So, now Raju has 2700 USD left.

This makes the Raju worried. He is worried. It was his first-ever trade and it gave him a 300 USD loss. Now, he is fully occupied by his emotions (in his mind the money doubling is also going on), and he thinks that he can still recover as it was his first trade. In the next trade, he will do better Technical analysis and will recover from loss and will continue his journey towards doubling his portfolio. At this time, currency X may show some little recovery, as no currency goes straight up without coming down, and no currency goes down straight without breaks. So, he goes for another trade-in the same currency (which we can call a revenge trade), but unfortunately, the same thing happens again, so he loses another 10% (i.e., 2700 x 0.10 = 270 USD). So now his portfolio is 2430 USD. This new portfolio is about 19% lower than his original 3000 USD portfolio.

In just two trades he has lost about 20% of his portfolio. This is a significant loss and it's not easy to recover from such loss at the very start of the trading journey. It may lead to further revenge trades, combined with inexperience this may further lead to losses, and ultimately loss of all portfolio or mind state that gets confirmed that crypto is shit, and it’s fake, people are telling lies about making money in it.

Raju case is a classic example of the possibility that how a new trader is just two bad trades away on the path of bankruptcy if he does not consider risk management in trading. Some people may rightly think that what if Raju had made money in the first or second (or both) trade? Yes, that is also a possible scenario, but such fortunate does not happen consistently in trading. The market is cruel, and it does not care for anyone.

Remember, ignoring risk management means that you are just two trades away from failure. Now let’s analyze, where Raju went wrong and how he could have done better while considering the risk management in his trading.

Risk Management and Mature Trader (Mr. Babu)

Mr Babu has several years of experience in trading forex and cryptocurrencies. He knows very well how to deal with risk management. Babu also got 3000 USD for experimentation. He did his technical analysis and wants to take a trade-in Currency X.

Before entering the Trade, Babu set his risk limit at a certain level. For new traders, it’s important to keep the risk level at 1% of the capital for the first six months.  So for sake of example, let's say Babu set his risk limit at 30 USD (3000 x 0.01 = 30 USD). What does this mean? It means if he starts his trade, and by any time if his losses reach 30 USD, he will exit the trade immediately, without waiting for the market to recover and lose more. Same time, he also decides to exit the trade if a profit reaches a certain level, say 5%. This implies that he will exit profitably if the market reaches 5% profit.

Compare Babu's investment case with Raju's. Raju wants to make money double, and Babu only wants 5%. Rajj was waiting until his exit of the trade at a 10 % loss, Babu will exit as the trade is touching a 1% loss. 

Babu is following a proper risk management approach. This will save him from a big unbearable loss. How does this work? Let's say, Babu sets his risk at 1%, and he loses the first trade. He will lose 30 USD only. Now his portfolio is 2970. Babu goes for another trade, let's say he loses again, but due to stop-loss he again loses only 1%, so now his portfolio will be around 2940 USD (2970x0.01 = 29.70 USD). If he continues making loss trades, in 10 trades, he will be bearing the same losses as Rajju will be doing in his first trade.

                It is common sense, that a trader even very bad, would not make all 10 trades in a loss. So, given that Babu has set a 5 % return (profit-making exit point), a one-trade success in 5 trades will make Babu break even. And if he took more than 1 trade profitable in 5 trades, he will be a net gain.

Case study of Risk-Management & Power of 1%

Consider below A Trade setup of Babu. He wants to make this trade setup with his 3000 USD total portfolio. His top-level where he want to exit profitably is 28.17% higher than the current price of the currency. At the same time, the stop-loss, where he wants the trade to close to avoid further losses is 10.57% below the current price of the currency.

 Now how he can apply this 1% rule as follows.  Here is the math. 

First, he must think of his total portfolio that is 3000 USD and that he cannot make a loss of more than 1% (30 USD) in a single trade. After knowing that, he needs to divide his total portfolio by the loss level he wants to keep (10.57%). This gives 3000/10.57 = 283.84 or 284 USD.  This is the amount (284 USD) he should invest in this trade if his total portfolio is 3000 USD. Because, if he loses this trade, he will be losing 10.57% of 284 USD which is 30 USD (283.84 x 0.1057 = 30 USD), exactly equal to 1% of his total portfolio. If on the other hand, he is successful he will be making 28.17 % of 284 which is equal to 80 USD (i.e., 284 x .2817 = 80 USD).

                In this practical example, Raju can lose only 30 USD in a trade, if he does two-loss trades, he will be losing 60 USD, and in one gain trade, he will be getting 80 USD. Still, he is on the net again with 20  USD, even if he lost the first two trades.

 

Raju's Dream of Doubling Portfolio With Risk Management

 Can Babu double his portfolio using this risk management technique? If yes how long it will take?

To answer these questions, we need to learn the concept of compound growth. Compound growth is an approach used by economists and financial experts to calculate the growth of financial assets (mostly) over time if one knows its rate of increase.

                For example, if we know that I have a certain amount now (let say “P” USD), and I know that I am earning by trading some return (let say “r” rate), then my future amounts (“F“USD) in “n” trades can be calculated as follows:

                F = P ( 1 + r)ⁿ

Let me explain it in more simple words with numbers. Let say Babu has 3000 USD. He earns 1% of it every day (3000 x 0.01 = 30 USD) and let say he keeps on doing it for the next two and half months approximately, i.e., 70 days. Then this formula can be applied as:

   F = 3000 (1 + 0.01)⁷⁰ =   6020 USD

That means, with given conditions, Babu will be taking his portfolio from 3000 USD to 6020 in 70 days given that he keeps on earning 1% of his portfolio every day. Yes, there may be some loss trades too, but if his net gain should be 1%.

Please note, I took 70 days deliberately, to show you the double amount. However, using the above formula you can try any other number to find the changes in your portfolio with time. Telling it slightly differently, if Babu has 3000 USD, he keeps on earning 1% every day, by end of the year (365 days), he will have his portfolio turned into 113350 USD.  This is a 3678 % increase in the initial portfolio of Babu. 

 This is the real power of the 1% Rule

Please note, that it does not mean that everyone can do that, it depends on a lot of things, but theoretically, it is possible to grow your funds by 3678% in one year, if you can make a net 1% increase every day to your portfolio. However, to reach that level you need time (for learning and trading successfully), patience, risk management, controlling your emotions and greed.

Finally, below, I am placing a few rules for risk management for new traders.

Rules for Risk Management

1.      Never trade without stop loss

It is simple, whenever you want to enter in a trade, do set the risk, and also the point of closing your trade with profit. It is like setting the risk and reward of every trade you want to enter before you enter the trade.

2.      Never – ever move your stop loss

Most of the traders keep on moving their stop loss to the lower and lower level when their stop loss level is about to execute. Never do that. That is, do not move your stop loss when it reaches execution. It simply means that the setup you had for trade is no move valid which tell you to enter into the first place. There is no shame in losing a trade. You entered the market while reading it properly, and the market did not work as you were thinking. Then, it is better to walk out with pride while accepting your misreading of the market, rather than waiting for reaching the point, where the exist is painful and shameful.

3.      You have to be disciplined

You have to be disciplined in your trading to follow these rules.