Risk Management
Technical Analysis • Critical Foundation
Effective risk management protects capital, controls losses, and preserves the ability to trade another day. Master position sizing, stop-loss strategies, and portfolio-level techniques to ensure long-term trading success.
1Position Sizing
Determine how much capital to allocate per trade based on your risk tolerance and strategy.
Fixed-Dollar Method
Risk the same dollar amount on each trade (e.g., $500).
Fixed-Percent Method
Risk a set percentage of equity per trade (e.g., 1–2%).
Volatility-Based Method
Adjust position size by asset's ATR or standard deviation to equalize dollar risk.
Kelly Criterion
Mathematical formula that maximizes growth by using win probability and payoff ratio.
| Method | Definition | Pros | Cons |
|---|---|---|---|
| Fixed-Dollar | Same dollar risk each trade | Simple; consistent | Doesn't adapt to changing volatility |
| Fixed-Percent | Same percentage of equity | Scales with account size | Assumes constant volatility |
| Volatility-Based | Position size = risk ÷ volatility | Normalizes risk across assets | Requires accurate volatility estimate |
| Kelly Criterion | W/L - (1-W)/R | Maximizes long-term growth | Highly sensitive to input errors |
Kelly Criterion Formula
f* = (W/L) - (1-W)/R
Important: Choosing a sizing method aligned with your psychology and market conditions is crucial.
2Stop-Loss Orders
Stop-loss orders automate exits to limit downside and protect capital from significant losses.
Market Stop
Converts to market order when trigger price is hit; guarantees exit but not price.
Stop-Limit
Converts to a limit order at trigger; controls exit price but may miss execution.
Trailing Stop
Stops follow price by fixed amount or percentage; locks in gains on trending moves.
OCO (One-Cancels-the-Other)
Pair of orders where one execution cancels the other (e.g., profit target + stop-loss).
| Order Type | Execution Behavior | Advantage | Disadvantage |
|---|---|---|---|
| Market Stop | Market order at trigger | Ensures execution | Slippage risk |
| Stop-Limit | Limit order at trigger | Controls exit price | Possible non-execution |
| Trailing Stop | Moves stop with price | Locks in profits | Whipsaws in volatile markets |
| OCO | Two linked orders; one cancels the other | Fully automated exits | Complex setup |
Stop Placement Strategy
Place stops beyond logical support/resistance or volatility thresholds, not at round numbers. Use ATR or recent swing points for dynamic stop placement.
3Risk-to-Reward & Profit Targets
Balancing potential gain against risk ensures disciplined trading and long-term profitability.
Risk-to-Reward Scenarios
| Scenario | Entry Price | Stop-Loss Price | Profit Target | Risk:Reward |
|---|---|---|---|---|
| Bullish Breakout | $50.00 | $48.00 | $54.00 | 1:2 |
| Short Reversal | $75.00 | $77.00 | $71.00 | 1:2 |
Guidelines
- • Minimum 1:2 risk-to-reward ratio
- • Higher ratios compensate for lower win rates
- • Consider commission costs in calculations
- • Account for partial profits at targets
Target Adjustment
- • Base targets on nearby support/resistance
- • Adjust for asset's volatility (ATR)
- • Consider market conditions
- • Use measured moves from patterns
Risk-Reward Calculation
Risk-to-Reward Ratio = (Entry - Stop) : (Target - Entry)
Example: Entry $50, Stop $48, Target $54 → Risk $2 : Reward $4 = 1:2 ratio
4Portfolio Management Techniques
Manage overall exposure and protect against correlated losses through systematic portfolio management.
Diversification
Position Limits
- • Cap position sizes (e.g., ≤5% per trade)
- • Limit sector exposure (≤20% per sector)
- • Avoid concentration in single assets
Asset Mixing
- • Combine uncorrelated assets
- • Mix timeframes and strategies
- • Include defensive positions
Correlation Monitoring
Use rolling correlation matrices to avoid hidden concentrations and ensure true diversification.
Best Practice: Monitor 60-day rolling correlations; avoid positions with >0.7 correlation
Hedging Strategies
Options
- • Protective puts
- • Collars
- • Put spreads
Futures
- • Index futures shorts
- • Currency hedges
- • Commodity hedges
ETFs
- • Inverse ETFs
- • VIX products
- • Bond ETFs
Volatility Targeting
Adjust leverage to maintain stable portfolio volatility across different market regimes.
Method: Target volatility = 15%, Current volatility = 25% → Reduce leverage by 40%
Drawdown Controls
- • Predefine max drawdown (e.g., 10%)
- • Pause trading if breached
- • Scale back position sizes after losses
- • Review and adjust risk parameters
Key Insight
Consistent monitoring and regular rebalancing maintain risk within acceptable bounds. Portfolio management is an ongoing process, not a one-time setup.
Best Practices & Common Pitfalls
Essential Best Practices
- Never increase risk after a loss—stick to your sizing rules
- Use multiple timeframes to validate stop-loss levels
- Backtest risk parameters on historical data before live deployment
Common Pitfalls to Avoid
- Avoid "moving stops" further away when under pressure
- Beware of over-diversification—too many small positions dilute returns
- Don't ignore correlation during market stress—diversification fails when needed most