Risk Management System Development
A Risk Management System in trading is a framework or set of procedures designed to
identify, assess, monitor, and mitigate the risks associated with trading activities. This system
helps traders minimize potential losses, manage their exposure to market volatility, and protect
their trading capital. The core components of a risk management system include setting risk
tolerance levels, position sizing, implementing stop-loss orders, and regularly reviewing and
adjusting strategies based on performance and market conditions.
Risk management systems are essential for successful trading, providing a structured
approach to identifying and mitigating risks. From ancient trade practices to modern financial
theories and sophisticated risk management tools, these systems have evolved to help traders
navigate the complexities of financial markets. By choosing the appropriate risk management
system, traders can better protect their capital, reduce emotional decision-making, and improve
their chances of long-term success.
We will explore the essential variables in a basic risk management system, understand
the importance of risk tolerance, and learn how to calculate and apply these concepts in your
trading strategy.
Types of Risk Management Systems
1. Static Risk Management System:
○ Definition: A system where risk parameters remain constant and do not adjust
based on changes in trading capital or market conditions.
○ Usage: Typically used by novice traders or in automated trading systems where
simplicity and consistency are prioritized.
○ Example: Risking a fixed percentage of the initial trading capital (ex: 2%) on
each trade, regardless of previous gains or losses.
2. Dynamic Risk Management System:
○ Definition: A system that adjusts risk parameters based on changes in trading
capital, market conditions, or trader performance.
○ Usage: Preferred by experienced traders who actively manage their risk
exposure based on market dynamics and their trading performance.
○ Example: Adjusting the percentage of trading capital at risk per trade based on
current account balance. If the account balance increases, the risk per trade may
increase proportionally, and vice versa.
3. Value at Risk (VaR):
○ Definition: A statistical method used to estimate the potential loss in value of a
portfolio over a defined period for a given confidence interval.
○ Usage: Commonly used by financial institutions to assess the risk of their
portfolios and determine capital reserves.
○ Example: A VaR calculation might indicate that there is a 5% chance that the
portfolio will lose more than $1 million over the next month.
4. Hedging:
○ Definition: The practice of using financial instruments, such as options, futures,
or other derivatives, to offset potential losses in an investment.
○ Usage: Used by traders and investors to protect against adverse price
movements in an asset.
○ Example: An investor holding a portfolio of stocks might use index options to
hedge against a potential market downturn.
For the purposes of retail trading, we will only worry about a Static, or Dynamic Risk
system.
Key Variables in a Basic Risk Management System:
1. Trading Capital (TC)
○ This is the total amount of money in your trading account. It represents the
financial base from which you will conduct your trading activities.
2. Daily Drawdown Limit (DDL)
○ The maximum allowable loss for a single trading day. Setting a daily drawdown
limit helps prevent significant losses and protects your trading capital from being
depleted in a single day.
3. Profit Drawdown Limit (PDL)
○ The maximum allowable decrease from the highest point of profit achieved. This
helps protect your gains by ensuring you do not lose a significant portion of your
profits once you’ve achieved them.
4. Risk Tolerance (%)
○ The percentage of your trading capital you are willing to risk per trade. Risk
tolerance is a critical factor in maintaining control over your trading activities and
avoiding excessive losses.
5. % of Trading Capital at Risk per Trade
○ The actual dollar amount or percentage of the trading capital you are willing to
risk on any single trade. This ensures that each trade is appropriately sized
relative to your overall capital.
6. Maximum Allowable Trade Risk
○ The max allowable amount of money you can use on any given trade. This is
based on your risk tolerance level and trading capital
Calculating Maximum Allowable Trade Risk (MTR)
To manage risk effectively, you must calculate your maximum allowable trade risk based on your
risk tolerance and trading capital. Knowing what your max trade risk can be for any given trade,
allows us to quickly calculate our position size when we are potentially trading very fast on the
smallest time frames. Remember, just because we have a maximum allowable trade risk DOES
NOT MEAN WE SHOULD USE IT IN FULL ON EVERY TRADE.
Formula:
Allowable Trade Risk = Portfolio Value (PV) × Risk Tolerance (RT)
Example using your own capital:
● Portfolio Value (PV): $20,000
● Risk Tolerance (RT): 2%
● MTR = $20000 * 2% = $400
Example using Prop Desk Evaluations:
● Portfolio Value (PV): $2500 (based on a 50k evaluation with a 2500 drawdown)
● Risk Tolerance (RT): 2%
● MTR = $2500 * 2% = $50
Some of you may be thinking right now… Well $50 is certainly not a very big position size.. How
am I ever going to make money? We have to remember, this trade risk does not equal position
size! This simply is giving us the total amount we can lose IF our stop loss is hit. Our position
size is calculated after we know a few more pieces of information.
Calculating Position Size (Futures Contracts)
Once you know your allowable trade risk, you can calculate your position size using the value
per point of the contract you are trading and your trade drawdown (the distance from your entry
to your stop loss).
Value Per Point:
● E-mini (ES): $50 per point
● Micro E-mini (MES): $5 per point
Trade Drawdown:
● Entry Price - Stop Loss Price = Trade Drawdown
○ Example: Entry = 5591, Stop = 5590, Trade Drawdown = 1 point
Applying the Risk Management System
1. Set Your Baseline Risk Tolerance:
○ Use a fixed percentage (ex: 2%) for all trades initially.
○ Adjust % based on the confidence level in each trade setup as you develop.
i. Example:
A+ Setups = 2-5% B+ Setups = 1-2% C+ Setups = 1% Test Setups = .5% or Sim
2. Calculate Your Allowable Trade Risk:
○ Use the formula to determine the maximum dollar amount you can risk per trade.
3. Determine Position Size:
○ Based on the structure around your trade, calculate the drawdown and value per
point. Then calculate the number of contracts you can trade.
4. Adjust Position Size Dynamically:
○ Use the maximum allowable trade risk as a guide but adjust based on market
conditions, volatility, and confidence in the trade setup.
The purpose of a simple risk management system like this is so that we can have an
idea what our maximum trade risk can be given the type of trade we are taking. Once we know
that, we keep an eye on the charts and its structure. We find out where our best entry is and
where the stop loss will be. Then it becomes simple math we can do in our heads to gauge our
position size. Controlled position size leads to less emotional decisions.
As you are just starting out, you will not know what your best trade setups are. You will
not know how to really adjust for confidence until your system becomes tested and validated.
Until then you can keep it simple and just use one risk tolerance % for all your trades. 2% rule
will usually be fine for most people, although some of you may be more comfortable with slightly
more or less tolerance. A static risk management system using a 2% risk tolerance will be able
to withstand 50 losses in a row before the account is blown.
Using this risk system is going to allow you to scale up as your account size grows. The
more trading capital in your account, the more you can risk at your risk tolerance %. I do
recommend that if you are not consistently profitable, to avoid scaling up to fast if your account
size happens to grow quickly. Sometimes it makes more sense to keep your trading capital
static even though you are profiting. This will also help ensure you are keeping your trading
capital protected.
Another benefit to this system is the ability to dynamically shift our position size on the
fly. IF we know our maximum trade risk, but the market is very volatile today, then we can widen
our stop loss and that will effectively reduce our position size. This keeps us safe in a higher risk
situation and increases the likelihood of success of the trade with a wider stop loss.
Understanding and implementing a risk management system is crucial for successful
trading. By calculating and adhering to your risk tolerance, you can protect your capital,
minimize losses, and improve your trading performance. Use the mathematical formulas and
strategies discussed today to develop a disciplined and effective risk management approach.
Always Remember,
Structure Dictates Risk & Risk Dictates Size
