The Art and Science of Risk Management for Short-Term Trading

Short-term trading has the potential to make you a lot of money.

Unfortunately, so-called trading “experts” can make it all look too easy: buy a stock, sell it high or short it low, and rake in the money. What could go wrong?

It doesn’t take long to realize that losing money is a real possibility. Some traders don’t discover this fact until they’ve watched a trade go to zero and lost all their capital. 

We don’t want that to happen to anyone, and with a fundamental understanding of risk management for traders, there’s no reason it should happen to you. 

It may help to think of risk management as mental conditioning, similar to physical fitness conditioning. If you don’t exercise regularly and maintain a base fitness level, you’re far more likely to get injured and taken out of the action. 

In this article, we’ll cover the fundamental risk management strategies that short-term traders need to understand to minimize losses, maximize gains, and continually improve their win-loss ratios. 

What is risk management for Short-Term Traders?

According to the U.S. Securities and Exchange Commission, finance risk “refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision.” Put another way, risk is an expression of how much money you can lose and how likely you are to lose it. 

Every investment contains inherent risk, and the amount of risk is usually proportional to the potential gains. Trading risk management monitors such risk to minimize losses, while leaving room for market volatility and potential upside. 

Risk management isn’t a single set of metrics that you can set and forget about.

If you’ve ever learned to drive a car, sail a boat, or operate any complex machinery, you focused on the basics at first. Once those skills become automatic, you can operate the vehicle or vessel with unconscious competence, as you gain further skills. 

Risk management for traders is much the same. At first, it can feel overwhelming and tricky. As you gain experience and competence, you’ll intuitively adjust your strategy for different trading situations, and the process will flow naturally. 

Give yourself the grace to learn how to manage risk effectively. You won’t master it overnight, and you’ll learn to adjust risk as you continue to study your trades.

How Does Risk Management Benefit Short-Term Traders?

Risk management differs for short-term traders, swing traders, and long-term investors. Your approach’s time window will determine the metrics you use to build your risk management strategy.

Short-term traders should aim for a balanced risk management strategy optimized for intraday price movement. It brings a host of benefits, including:

Capital Preservation

First and foremost, a balanced risk management strategy helps you to maintain your available capital or buying power.

In prop trading, you earn buying power based on the success of past trades. Buying power isn’t the same thing as cash in the bank because it’s the firm’s money you can use in short-term trading activities.

The effectiveness of your personal approach to risk management will determine whether the prop firm increases your buying power or reduces it. 

Improved Profitability 

At a high level, you want to execute more winning trades than losing trades.

But a pure win-loss ratio or batting average won’t tell the whole story. Balanced risk management for traders means tuning your trades to deliver positive profitability. 

For instance, if you make three trades, it could look like this:

1. Bought 100 shares of ACME Anvils Inc. at $5.06 a share: total cost $506. Sold at $4.56 (a loss of 10% or $50). 
2. Bought 50 shares of Big Pop Dynamite LLC. at $10.35 a share: total cost $517.50. Sold at $10.75 (a gain of 3.7% or $20)
3. Bought 200 shares of Screwy Tools Co. at $2.01 a share: total cost $402. Sold at $2.26 (a gain of 12% or $50)

Your win-loss ratio is 2:1, but your percentage gain is only 5.7%, and your total profitability is just $20. 

As you develop your risk management plan, you can begin to plan specific trades around your success metrics. In some cases, a large trade with a smaller price movement could help compensate for a minor trade with a much larger price movement and lost money.

Regulated Emotions

On paper, trading is about math, statistics, risk, and reward.

But it’s also about the psychology and emotions of thousands of other traders working toward their own goals. 

Human emotions can be beautiful and terrifying. The science of risk management allows you to build guardrails that can prevent impulsive deviations from your original plan. 

At first, you may find it challenging to honor the limits you set for trading activity. Part of you will leap at the possibility of a trade breaking out and earning you a major win—even if the odds aren’t strong. 

Complying with your risk management parameters allows you to protect against these urges. To put it bluntly, emotion-driven traders don’t make good career traders. 

Adaptability

The best risk management strategy can be adjusted (within reason) based on market conditions and shifting priorities. Your strategy shouldn’t be too loose, but it can’t be too tight either.

A wise trader has the experience to know when to adapt risk tolerances and how much to adjust them. 

Nobody is born with this knowledge; it’s only earned through trial and error. Make live trades with real money and then analyze your behavior. Look for inconsistencies or moments when things didn’t go as planned. 

Improved Leverage

Leveraged trading is an advanced strategy that requires traders to have a sophisticated understanding of risk management.

In short, a leveraged trade is where you can use a small amount of capital to execute a much larger trade. 

For example, your broker might allow you to put up only $5 of capital for a $50 trade, loaning you the remaining $45.

Leverage cuts both ways, delivering astonishing gains and devastating losses. As such, it must be backed by a deep understanding of the risk to your portfolio. 

As you build up a track record of successful trades using standard buying power, you move closer and closer to earning the right to make leveraged trades. 

Beginner Risk Management Strategies

While there’s no one-size-fits-all risk management strategy for short-term trading, there are some strategies that you can follow and adapt to your liking.

The strategies below are best designed for beginner short-term traders. Consider starting with any of these when planning risk management for trading.

Risk-Reward Ratio

In the simplest terms, the formula for calculating the risk-reward ratio for a trade is: potential loss / potential gain. 

If you invest $1 and expect the trade to return $2, your risk-reward ratio is 1:2. 

How you calculate the potential gain of a trade is subjective. Using concepts such as price support and price resistance will help you make realistic projections about return, but there isn’t a foolproof method. 

It may seem obvious, but you only risk the money you put in in most trades: invest $1, and you can only lose $1.

In a leveraged trade, you stand to lose the money you invest plus the money you borrowed from the broker to execute the trade. If you invest $1 and the broker lends you $49, your risk is $50, not $1, because if the trade fails, you lose your and the broker’s money. 

A commonly recommended risk-reward ratio for short-term traders is 1:2. 

Stop-Loss Orders

This is one of the most critical tools for short-term traders to understand. A stop-loss order is a set of instructions a trader gives to sell an asset if the price falls to a specified level. 

Let’s take one of the trade examples from earlier.

If you bought 100 shares of ACME Anvils Inc. at $5.06 a share and set a stop-loss order at $4.81 (or 5%), then your upfront cost would still be $506, but you would have automatically sold the stock at $4.81 and only lost $25. 

Using a stop-loss order allows you to lower your risk far below your investment baseline. While setting your stop-loss order under 10% is a good starting point, you should know that many traders use 3%-8% stop-loss orders as a standard. 

As you gain experience with this risk management tool, you can consider using a trailing stop-order. This one, unlike the standrard which is fixed, moves in accordance with the stock, preventing you from constantly having to adjust it.

Diversification and Correlation

Diversification is beneficial if you take the time to evaluate the various risks and correlations for each position.

For example, it would not be wise to choose companies that would be negatively impacted by a large increase in the price of oil, such as plastics and global shipping. 

Therefore, you should consider investing in the best companies across all sectors, such as finance, technology, healthcare, and utilities.

This could mean placing a buy trade on companies like Tesla, Nvidia, and Google, as these companies often work well when the economy is in good health. These stocks will often decline when the market retreats.

A popular approach to risk diversification is to focus on ETFs (exchange-traded funds), which are baskets of securities that you buy a portion of the same way you can buy stock in a company. Essentially, you’re relying on someone else to create a diverse pool of investments. 

Overnight Trades

Holding a trade overnight is usually a bad idea for short-term traders.

Swing traders often hold assets for multiple days, while long-term investors hold them for months or years. Each type of trader develops risk management techniques that fit their portfolio and overall strategy. 

Short-term investing is predicated on a strategy where the trader closely monitors each open position and responds to real-time price action. 

The risk management plan for a short-term trader should ensure that all trades are closed in the overnight session. The benefit of doing this is that it protects you from sudden events that happen when you cannot trade. 

Size Your Trades

You should always have the size of your open trades clearly written down. In all trades, you should always ensure that you risk only a small portion of your account.

In other words, you should risk a slight portion of your account in all trades that you do.

Do you recall the earlier example of the three trades, where one lost money and two made money?

Let’s say all those trades were open at the same time. That would mean your open positions would be equal to $1,425.50.

Let’s say your total buying power is $20,000, which means your total portfolio risk is 7%. As a general rule, it’s a good idea to limit your potential drawdown to less than 20% of your buying power. 

It might sound simple enough to limit your open positions, but if you’re watching a trend develop, the temptation to re-enter the market will be strong. You might want to take two or three positions on the same stock. How will each position affect your individual position risk and portfolio risk? 

Advanced Risk Management Concepts

As you become comfortable with the parameters of your risk management strategy, you can begin adding in more sophisticated concepts.

This way, you can build upon basic strategies, towards more complex ones.

Value at Risk (VaR)

Despite the seemingly obvious name, VaR is derived from a statistical model that quantifies the potential for loss in a security over a given time frame.

It’s usually expressed with two percentages and the time frame assessed.

For example, an asset with a 5% 60-day VaR of 20% has a 5% chance of declining in value by 20% over two months. 

VaR is computed by one of three statistical models. Although the example we gave is a long time horizon, VaR is a valuable risk management tool for short-term traders.

Scenario Analysis

Scenario analysis is another strategy that allows you to assess how the value of a portfolio might shift over time based on a series of “what if” situations. 

Scenario analysis allows you to analyze your portfolio across various events, including highly likely or unlikely events. This can allow you to evaluate how those outcomes pair with your risk appetite and management strategy, so that you can adjust accordingly. 

A popular type of scenario analysis is stress testing, where you evaluate the performance of your portfolio against extreme or unusual market conditions, sometimes referred to as black swan events.  

Two-Day Low Strategy

The two-day low strategy is where a trader puts a stop-loss order of 10 pips (or the equivalent) below the two-day low price for the asset. Passing the two-day low is a reasonable indicator of a downward trend. 

A pip is a FOREX term that refers to the smallest unit of price change in a currency pair or one-hundredth of one percent (four decimal places). But the equivalent for other assets would be the smallest change unit. 

Parabolic Stop and Reverse 

Parabolic stop and reverse (SAR) is a popular technical indicator for determining where to place a stop-loss order, but it’s also one of the most easily confused and misused indicators.

Parabolic SAR is only useful with candlestick charts when the market is trending. If used during other conditions, the results will not be a good trading guide. 

SAR can confirm which direction an asset is likely to move in. When dots appear above the asset’s price, it means it’s likely to continue downhill. If the dots appear below the asset, it tells you that its price will likely climb. 

Due to its complexity and tendency to confuse inexperienced traders, we recommend that you study how SAR works and use it extensively in a trading simulator before you use it in live trading. 

Keep Short-Term Trading Risk Under Control

Risk management for traders is all about building guardrails to prevent you from losing your capital and leaving your trader career demoralized. 

In one sense, risk management is strictly about math, statistics, and understanding the historical behavior of the market. In another sense, the factor most likely to unravel your careful risk planning is your own emotional and mental state. 

As you practice self-awareness around your trading tendencies, you can counteract behaviors that undermine your strategy. 

Risk management is a skill that every short-term trader needs to master to have a long, fulfilling career. It may appear like tedious work and calculation at first, but it’s worth it. 

If you’re managing your risk appropriately, it’s possible to make great money in short-term trading with a win ratio of 40-50%. The best traders don’t win 80-90% of the time, but they know they don’t need to. 

At Real Trading, we encourage you to study and design your own risk management strategy. With it, you’ll be on a good path to success.