A great day trader understands the importance of a good risk management strategy and takes the necessary steps to develop the skill and adjust their approach to manage risk more adequately each day, week, month and year.
No trading strategy is perfect, and losses are bound to creep in. That is why a risk management plan is crucial for investors and traders. A solid plan helps keep losses from substantially damaging a trading account.
Risk Management Techniques for Day Traders
Traders use risk management to reduce losses and manage account balances. These simple risk management strategies can be used to protect your accounts.
The One-Percent Rule
A common rule followed by traders is the one-percent rule. This rule suggests that a trader shouldn’t risk more than 1% of their capital on a single trade. So, for example, if you have a $10,000 account, no one position should risk more than $100.
The amount of risk a trader takes per trade varies depending on their risk tolerance. Some traders risk 2% if they feel confident in their strategy or a specific position, while others who are more risk averse may drop to 0.5%. The general thought is to ensure a trader is not holding too much risk, as anything can happen when in an open position.
Setting a Stop Loss
Stop losses are vital to ensure your losses are not substantial. Setting a stop-loss point means that if a trade reaches a specific price against your position, it will be automatically closed at your pre-determined price point, which should help to limit your losses before they spiral. Be aware that stop losses are not always foolproof and can be prone to slippage in volatile markets.
Traders should also set a take-profit level, which will depend on the strategy and unique individuals of the trader. A take-profit ensures your position is exited at a pre-determined price in the direction of your trade and level you believe price action may turn against you.
Spreading Risk
Another successful strategy is to diversify your positions. Holding too much of one instrument can be extremely risky. However, spreading your risk across a range of instruments or stocks can be vital and also improve your opportunities.
This process can be achieved by trading or investing across various markets. But it is still vital that you only risk what you are willing to lose.
Stick to Your Plan
Following your trading plan can be challenging, and traders can be tempted by other strategies and opinions. For example, if you are convinced that the price will go in a certain direction, you may be more inclined to risk more than your plan dictates and suffer a larger-than-usual loss. Deviating from your initial plan can be a mistake and cause severe losses to your account.
Avoid Highly Volatile Periods
Volatility drives the market, but it is not always beneficial to traders. Extreme cases of volatility can lead to large swings in prices and can cause an impactful loss. As a result, many traders choose to avoid highly volatile periods, such as during economic data releases.
Upcoming data releases such as U.S. inflation or non-farm payrolls can have a significant impact on the markets, and the Fed’s rate decisions can cause volatility that some traders may prefer to stay clear of.
Position Sizing
You can manage risk by properly sizing your positions based on your risk tolerance and specific trade setup. When you control the size of each position, you limit the potential impact of a losing trade.
What is the One-Percent Rule?
The one-percent rule is an excellent risk strategy that defines the risk held on each individual trade. The rule stipulates that no more than 1% of your total capital should be risked on a single position.
This strategy can help protect a trader’s account from excessive loss. It’s a good way to keep your losses in check and remain consistent on your risk amount on each trade. If your trading strategy is successful, then the one-percent rule should work effectively and provide stability.
Limiting the risk you take per trade can ensure your long-term survival. The probability of seeing at least three consecutive losing trades within a 50-trade period is 95.8% if you have a 60% winning percentage. Managing that risk with a prudent strategy can be the difference between success and failure as a day trader.
How to Set Stop-Losses and Profit Targets
An important risk management tool to have in place is setting stop losses and profit targets. An effective stop loss or profit target can make or break your trading strategy.
Stop-loss: A stop loss is an order from you to your broker to close your position when the price hits a pre-defined level against your trade. The position will be closed automatically if the price reaches this level. A stop loss helps you to minimize the size of the loss you potentially take, making it an effective risk management tool.
Placement is important with a stop loss, as the price may move against you before turning around. The primary goal is to limit losses before they escalate.
Profit targets: Profit targets are just as vital to a trader's strategy to ensure the trader takes money off the table before the price turns against them. A trader should place a profit target at a level that the price is likely to be able to reach, which can be determined using support and resistance levels or other tools such as the Average True Range).
Emotions can play an important factor in trading, and setting pre-determined levels before you have entered a trade can help prevent them from impacting your judgment. It is important not to be too greedy and aim too high but also to take as much profit as possible.
Day Trading Glossary
Trading can throw a number of terms and definitions at you that can trip you up. Here are a few words and phrases common to day trading to help you along the way.
- Expected return: The expected return is the profit an investor anticipates on any given investment or trade. It is a great way to plan your trades effectively and measure your risk beforehand.
- Diversify: To diversify in trading involves allocating capital to different assets to minimize exposure to a specific asset or risk.
- Hedge: Hedging is a standard practice many traders use to limit risk across an instrument or asset. Hedging involves taking an offsetting position to reduce the risk in your initial investment.
- Downside put option: A downside put option is a strategy typically used to reduce the risk of a position — to hedge. Downside puts gain value the more the price of an underlying stock or security decreases.
Compare Brokers
To implement day trading risk management techniques, it is necessary to trade through a broker. If you do not already have a brokerage account, you can see some of the best brokerages available to trade with below.
- Best For:Futures TradersVIEW PROS & CONS:securely through Apex Trader Funding's website
- Best For:Stock TradersVIEW PROS & CONS:securely through Trade The Pool's website
- Best For:Seasoned and Undercapitalized TradersVIEW PROS & CONS:securely through Top One Trader's website
- Best For:Experienced and beginner forex, indices and metal tradersVIEW PROS & CONS:securely through The5ers's website
Frequently Asked Questions
What are the main risks of day trading?
The biggest risk of day trading is the financial losses that can occur. Many new traders can find day trading challenging. They may suffer substantial losses if risk management is not done correctly.
How much should a day trader spend per day?
There is no required amount a trader should spend on any given day. The more capital a trader has can lead to larger returns, but it can also result in significant losses. Money in a trading account should only be money a trader can afford to lose.
About Sam Boughedda, Stock Market Analyst
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