Risk Doesn’t Have To Be Risky

Posted By Robert On Wednesday, December 11th, 2013 With 0 Comments

If I asked you what is the most important aspect of your spread betting system, it’s likely that many of you would say “finding the right trade set-ups”, which is what we’ll look at shortly in the next chapter. But you’d be wrong.

Identifying the very best trading opportunities won’t save you from ultimately visiting the poor house if you fail to manage your downside (and for that matter, upside) risk properly. I really believe that if you look after the downside, the upside will pretty much take care of itself. To put it bluntly: you can’t ensure or even predict that your latest penny stock pick will become a ten-bagger, but you can ensure that it doesn’t take your whole account down with it if it goes bust.

Professional poker players know “when to hold, and when to fold”, and that’s how they make money consistently over time. Great golfers are not the ones who hit the biggest shots, but the ones who make the fewest mistakes.

Risk management is so important that it deserves a section all of its own, and this section deserves to come before the one in which we attempt to identify good trading opportunities. But before we talk about risk management, we need to clear up the possible confusion between risk management and money management. They’re similar, but not the same.

When I posed the question, If you could give just one piece of advice to a spread bettor, what would it be?  You must be careful, and manage your risk.

Putting risk first is paramount. We interviewed many great traders and almost all of them told us that controlling risk religiously is far more important than actually making money. The latter will take care of itself. Most new traders, however, do not internalise that paradigm, which leads to a high probability of an account blow-up at some point during their career. Do not make that mistake. Be smart. Follow the wisdom of the great traders.

Money Management and Risk Management

Money management is often the last thing on the mind of the new spread bettor who is looking to make big money with very little effort. If you bet big you might win big, but sooner or later you will go bust. Let me explain using the analogy of a casino.

The casino’s roulette wheel is biased very slightly in favour of the house, giving them a slight edge of (let’s say) 51% of the time they win and 49% of the time one of their clients wins. This very slight edge means that the casino is statistically guaranteed to come out ahead and make money in the long run over a large number of bets. But the casino owner is still in danger of going bust if he allows a single “high roller” client to place a single big bet equivalent to the casino’s cash pile. So they don’t allow it, and they take a more actuarial approach to making small amounts of sure money over time.

In a similar fashion, a good spread bettor can make sure money over time with only a slight “edge” in the market stemming from good strategy; as long as he (or she) is never tempted to “bet the farm” on just one spin of the metaphorical roulette wheel. In short, a spread bettor should think more like the casino owner than the casino punter – by practising sound money management.

What this means in practice is risking a mere fraction of your available funds on any one bet, commonly (for successful spread bettors) as low as just 1% of available funds. It means “risking” just £10 on each serial or parallel bet in a modest £1000 spread betting account. On this basis, no one bad bet can ever wipe you out, and you can also survive the inevitable extended run of bad luck that you will surely suffer at some point. The simple calculation is that you can suffer up to 100 losses in a row at £10 per loss before your £1000 trading funds run out.

So much for money management, but this chapter is meant to be about risk management. So let’s continue with the question…

Know your Risk Reward Ratio

Throughout a lot of these rules we talk about managing your capital and managing your risk. Part of all this is the idea of keeping an eye on your Risk Reward Ratio whenever you open a trade. The best way to explain this is with a couple of examples.

Let’s say you’re opening a trade (€1 per tick) on a particular share at €15.00 (1500) and you put your stop at €10.00 (1000) – that’s where you think support is and you are hoping to take profits at €20.00 (2000) – that’s where resistance is at. In this kind of trade your max win is €500 and your max loss is €500. So your Risk Reward Ratio is 1 to 1. Effectively 50/50, or the flip of a coin, not good odds at all and not a good trade to be opening up.

Instead if you can open a €1 a tick trade in the same share with a buy price of €11.00 (1100) and your stop is still set at €10 (1000) and profit target is still at €20 (2000). In this scenario your max win if the trade goes as planned is €900 and your max loss if your wrong is €100. That’s a Risk Reward Ratio of 1-9, a much better trade to be taking on. Your risking €100 but have a profit target of €900. That’s more like it!

Hopefully from this example you will see the benefit of opening up 4 or 5 trades like this where if lets say three of go against you and you lose €300-400 but you get two right and you make €1000 plus.

Martingale and Anti-Martingale Money Management

Here’s a strategy that was popular among casino players in 18th century France and which is popular among novice spread bettors today:

When you bet £100 on the roulette wheel, and you lose, the next time you should bet £200, and the next time £400, and so on. Assuming 50/50 odds, you would only need your last (biggest) bet to come good in order to recover all of your prior losses… and more. This is the Martingale strategy that sounds seductive but which is fatally flawed.

If you hit a losing streak of nine bad bets in a row, which is perfectly possible, then on your tenth turn you would find yourself betting more than £50,000. Which is a far cry from your £100 initial bet, and I bet (pun intended) that this – plus the ‘almost as much’ that you have already bet in total – is more money than you took into the casino. So it’s ‘Game Over’ in just ten turns.

Although the Martingale strategy may indeed come good eventually when betting on stock indices, which unlike individual equities can’t conceivably go all the way to zero, most seasoned spread bettors know that their pockets are not deep enough to sustain the exponentially increasing bet sizes. So, in fact, they practice a form of anti-Martingale betting in which they bet less and less as their trading funds diminish.

Fixing an amount-per-bet at 10% (but it’s more likely to be just 1%) of available trading funds has an in-built automatic stabilizer. When you lose £100 of your £1,000 cash balance, the 10% rule ensures that next time you will stake only £90. After losing twice in a row you will stake only £81, and so on.

If you follow an anti-Martingale strategy, you won’t make a killing when your final big bet comes good; but at least you’ll ‘stay in the game’ long enough to realise your trading edge… if you have one.

So much for money management, but this section is meant to be about risk management. So let’s continue with the question…

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