The Art & Science of Technical Analysis: Market Structure, Price Action & Trading Strategies

CHAPTER 9

Risk Management

It is important to see distant things as if they were close and to take a distanced view of close things.

—Miyamoto Musashi, The Book of Five Rings (1645 CE)

Many of the problems of trading reduce to risk management. In most styles of trading, the trader’s job is essentially to manage the risk in trades, focusing on exiting losing trades at the correct points, and letting the upside take care of itself. Risk management is critical, as a few outsized losses can offset the profits from many winning trades; it does not take many errors to completely erode a trading edge. This chapter considers risk management from both practical and theoretical perspectives. We begin with practical, applied tools for risk management and position sizing that traders in all time frames will find useful. Many large losses come from having trades with inappropriate position sizes, and many traders do not understand the impact of trading size on the bottom line. The chapter moves on to a higher-level perspective on risk, incorporating some ideas from modern academic thinking and focusing on a few specific measures of risk, before concluding with a look at some of the less common risks that self-directed traders often overlook.

RISK AND POSITION SIZING

From a practical perspective, there are three main questions to answer with respect to risk. The first two have been addressed in the previous chapter, but the third is supremely important:

1. Where do we place our initial exit ...