The work of a short-term trader is deeply complicated. The desired goal is simple: make money by executing more profitable trades than unprofitable ones.
The obstacles are legion.
Short-term traders can trade in dozens of markets hosting thousands of assets worth trillions of dollars. The factors that influence price start broadly with economies, innovation, technology, demand, supply, and geopolitics, continuing narrowly into leadership changes and the shifting psychological states of individual traders.
It’s enough to overwhelm most humans and beg the question, how does anyone succeed as a short-term trader?
There are plenty of hard and soft skills that traders use to succeed. Chief among them is the discipline of risk management. For short-term traders, risk management is akin to safety checks performed by surgeons, aviators, and other high-stakes operators.
Checklists have become the standard practice in many professions—they are a system that allows people to focus on the moment, without trying to hold all the relevant tasks and procedures in their heads.
In his fascinating book The Checklist Manifesto, surgeon Atul Gawande says that “one essential characteristic of modern life is that we all depend on systems—on assemblages of people or technologies or both—and among our most profound difficulties is making them work.”
You need a risk management system in trading to protect your capital and guide your decision process in times of chaos or uncertainty.
This article will provide you with the tools for building your risk management system and guidance for making that system work.
Table of Contents
Understanding Trading Risks
Short-term traders face risk on two levels (at least). The first and most important is conceptual. Risk is the level of uncertainty in a given investment decision and the amount of money you stand to lose if it goes poorly.
The second level of risk is specific and contains multiple types, including:
Risk #1: Volatility
Volatility is a short-term trader’s best friend and worst enemy. An asset’s price movement allows traders to make money in the first place. Sometimes, this movement follows a recognizable pattern. Other times, it defies expectations and technical analysis, which is usually when it’s called “volatile.”
When faced with volatile price movement, you need to consult your risk management strategy. You may decide to adjust your procedure, such as setting wider stop-loss and take-profit orders, or you may decide to wait until the pattern settles.
The purpose of following a risk management strategy in volatile markets is that it will limit impulse trades and help you avoid trades based on false signals.
For example, the 2020 onset of the COVID-19 pandemic sent unpredictable tremors through global markets; some “safe” stocks cratered, while others soared.
Market volatility is a fact of life for short-term traders. It only becomes your enemy when you let it drive your trading decisions.
Risk #2: Liquidity
In an ideal world, there’s a buyer for every seller and vice versa. The truth is that it’s fairly common to pick an entry or exit point for an asset and discover it isn’t matched by someone willing to sell or buy. This may force you to adjust up or down until you find a match.
This concept is referred to as liquidity, and it roughly approximates the ease of entering or exiting a trade without affecting its price. Liquidity is also represented by the volume of an asset being traded on a given day.
Your risk management strategy needs to address various liquidity scenarios, such as:
- What is the minimum volume you need to enter or exit a trade?
- What is the maximum price adjustment you’re willing to make in a low-volume scenario?
Like ocean waves, liquidity is constantly changing. It may move in familiar patterns for the most part, but the last thing you want is to get smashed by an unexpected wave or sucked out to sea.
Risk #3: Leverage
Leverage is an optional type of risk, but important to understand. Some brokers will allow traders to borrow money for a trade, amplifying their buying power by orders of magnitude. Leverage is an attractive option, especially if you’re feeling confident in a trade or desperate to recover losses.
Leverage also increases your risk by orders of magnitude. In a standard trade, you only stand to lose the money you put in, so your risk-reward ratio is 1:X, where X is the return you anticipate. The trade could indeed go to zero, but your potential loss is obvious.
In a leveraged trade, you stand to lose the broker’s money on top of your own and potentially lose more than you stood to gain. The results can be catastrophic.
Risk #4: Personal
In prop trading, the risk of losing capital has more to do with earning potential and sustaining buying power than it does with losing personal funds. That said, if you’re making a career out of short-term trading, your reputation is at stake.
That doesn’t mean you need to win every trade or be out of a job. Most professional traders expect to win 40-50% of their trades, but they manage risk effectively to have 60% of their trades go south and still make a great living.
The biggest obstacles to that level of performance are personal discipline and psychological resilience. Global markets manifest as complex orchestrations of data, but they’re driven by the actions of emotional creatures: humans.
Inexperienced traders are prone to chasing their losses, hoping for a recovery, as well as acting impulsively when prices take a surprising turn. Opportunism is a vital attribute for short-term traders, but when it turns to impulsivity and a disregard for following a plan, it turns disastrous.
Disciplined traders manage their risk by learning when to trade, when to stop trading, and when to leave money on the table because the risk profile clashes with their long-term goals.
How Do Traders Typically Control Risk?
The five key elements of a balanced risk management system in trading include:
1. Risk-Reward Ratio
Money risked/ expected return = potential loss/potential gain. If you invest $1 and expect the trade to return $2, your risk-reward ratio is 1:2. Learning how to make realistic projections of possible returns takes practice. There isn’t a single standard or method.
2. Stop-Loss Orders
A stop-loss order is a set of instructions you give to sell an asset if the price falls to a specified level. Using a stop-loss order lowers your risk far below your investment baseline.
Based on the loss recovery concept from earlier, setting your stop-loss order under 10% is a good starting point. Many traders use 3, 5, or 8% stop-loss orders as a standard.
3. Diversification and Correlation
Investing in the best companies across all sectors, like finance, technology, healthcare, and utilities, is wise. This diversifies your portfolio and offers protection against correlated assets (i.e., different assets that are likely to rise or fall in price based on the same market forces or trends).
4. 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.
5. Trade Sizing
Planning the size of each trade within the context of your portfolio and open risk is vital for short-term trading. Even if you can technically afford to put 20% of your buying power into a single trade, that is rarely a wise decision. Short-term traders look at their trades as interconnected actions, where changing risk in one area also affects all the other areas.
How to Build a Risk Management System
Building a risk management system in trading is not like cooking a favorite dish using a family recipe—you’re allowed to change it, and your grandma isn’t going to audit you.
All this talk about discipline and following a plan could lead you to think that risk management is a set of rules you should never bend or break. That level of rigidity will lead you to grief.
Effective risk management is about establishing guidelines that help you trade smarter and more profitably, not put you in a virtual straight-jacket.
Once you understand the principles of sound risk management and gain clarity about your trading objectives, you can build a safe and useful system that keeps the excitement of trading alive.
Step #1: Define Your Trading Goals and Objectives
The best goals are SMART: Specific, Measurable, Achievable, Relevant, and Time-bound.
They should also align with your values and desires. For many people, short-term trading is a pathway to financial freedom and independence. Others love the challenge and thrill.
Imagine yourself in five years: what do you want your life to look like? After you’ve jotted down some ideas, begin reverse engineering those outcomes. What kind of choices can you make today that will move you closer?
Resist the temptation to set overly ambitious goals. There’s nothing wrong with big dreams, but simply driving harder and faster will lead to burnout and dissatisfaction.
Commit to becoming a short-term trader for the long haul and your lifestyle will become much more fulfilling.
Step #2: Choose a Trading Style
At Real Trading, we’re focused on short-term traders (sometimes called “active trading”) and the resources they need to be successful. That doesn’t mean we don’t believe in long-term investing (sometimes called “passive investing”), but it’s a different discipline.
It’s similar to the difference between surfing and sailing. Everyone is playing in the same ocean, but surfers need different skills and tools than sailboat pilots.
There are four primary styles of trading:
- Scalping: scalpers use small price actions—often measured in pennies or smaller—over very short time windows—often measured in seconds or minutes.
- Short-term (sometimes called “day” trading): technically, short-term traders focus on intra-day pricing and trading, rarely holding a position overnight. The term can also be used broadly to refer to scalping, day trading, and swing trading as a group.
- Swing trading: swing traders hold positions over multiple days, sometimes extending into months.
- Position (synonymous with passive or long-term investing): warren Buffet is probably the most famous passive investor. His company, Berkshire Hathaway, holds assets for years.
There isn’t a “right” way to trade, but it’s best to focus on one type of trading at once rather than splitting your attention across multiple trading strategies.
Step #3: Select Your Risk Mitigation Strategies
We’ve already highlighted a few types of risk, but there are many more. As a short-term trader, you must decide which to focus on.
For instance, some people like to trade exchange-traded funds (ETFs) to manage the risk of trading assets in consolidated or correlated industries.
Other traders rely on a few technical indicators that they’ve practiced with and understand thoroughly. If you’re constantly moving between indicators, looking for a confirmation of a trading opportunity, you’ll find it eventually—and probably lose money.
New traders need to experiment with different trading styles, assets, technical indicators, and risk mitigation techniques. That’s why a trading simulator is so useful! You can find a strategy that works for you before putting money on the line.
Step #4: Identify Entry and Exit Criteria
Gymnasts spend a lot of time perfecting their mount and dismount skills. It’s the setup for everything that happens in between. The same is true for short-term trading.
Poorly timed entries and exits will lead you to make unforced errors, lose money, and waste precious energy trying to recover. Following a few basic strategies will help you ace your exits and entries.
Entry: When to Enter a Trade
In retrospect, it’s easy to see when you should have entered a trade. But looking forward requires much more foresight and planning. New traders need to decide on the criteria for entry–gut feeling cannot be one of the criteria!
Technical indicators such as VWAP and moving averages are great ways to plan entries. You can also use price actions such as breakouts to plan your entry. Whatever you do, watch external market conditions such as news, earnings reports, and social media to look for impending changes.
Exit: When To Get out of a Trade
One of the most popular and highly recommended exit strategies is to set stop-loss and take-profit orders. A stop-loss order is usually set at less than 10% of the initial investment, but some traders like to set them as low as 3%.
This is due to the mathematical principle that it’s much easier to recover from a loss of 10% or even 11%, but after that, it gets exponentially harder to make up the losses.
A take-profit order is a way to exit, where you decide in advance how much profit you’re likely to make. This prevents you from chasing a trend so far that you get caught in the reversal and don’t make any money.
Step #5: Develop a Risk Management Matrix
Because there are so many factors to watch when managing risk, it’s wise to practice building risk management matrices. This can be a simple diagram on a notebook where you frame out the various threats, vulnerabilities, and factors affecting a trade.
Leave yourself space to rate each factor based on qualities such as likelihood, severity, and exposure.
How you fill out the risk matrix can vary based on the trade. Still, the principle is to create a simple tool to help you identify risks and evaluate outcomes to plan accordingly and respond quickly to the unexpected.
Additional Considerations
The discipline of risk management for traders will atrophy if you don’t actively improve. Here are some techniques short-term traders use to hone their risk management systems.
Analyze Previous Performance and Adjust
Journaling your trades is one of the cheapest ways to improve. Your trading platform should make analyzing basic metrics like win-loss, percentage gain, and frequency easy, but that’s just the surface.
Smart traders take the time to make notes about each trade, including their feelings, plans, and theories about what’s happening in the market. Later, they review the notes and analyze charts to see where they missed and which setups worked well. This also helps them develop new strategies to test.
Trading Simulators Make You a Better Trader
Even the best pilots, F1 drivers, and surgeons use simulators to train their bodies and brains in a low-risk environment. It allows you to make mistakes, test theories, and gain muscle memory for new skills.
The best traders know that split-second decisions can make or break a trade when the market is moving. Hesitation and uncertainty are a natural part of life, but you want to work them out of your system before you start putting real money on the line.
Some prop trading firms give their traders access to handicapped versions of the live platform. At Real Trading, our simulator is the same as our live platform, minus using real money. You get direct market access and all the tools you would expect during a real trading session.
You’ve heard the saying, “practice makes perfect,” but the truth is that you can practice bad habits, which just makes them worse. Intentional, reflective practice makes perfect, and a trading simulator is the best way to hone your craft.
Never Stop Learning
Becoming a professional short-term trader has never been easier. Platforms like YouTube put incredible trading resources at the fingertips of people everywhere. Digital classes, blogs, forums, and free webinars give you easy access to expert traders and peers who can guide your development.
You can live a lifetime as a professional short-term trader without discovering all there is to know. The one sure bet you can make is that as soon as you decide you know everything, you’re about to eat some humble pie.
Teachability and curiosity are some of the most profitable qualities that a trader can cultivate.
Risk Management Is an Art and a Science
There is a lot of math and science in short-term investing. Reading charts, calculating percentages, and separating noise from signal are all skills that traders should be able to do on the fly. However, risk management isn’t just a numbers game.
Risk comes in many forms and can be difficult to quantify. Effective risk management helps you identify relevant risks and tune your trading strategy when situations change. Some experienced traders may seem to work from gut instinct alone, but the truth is anything but.
Most professional traders have put in hundreds of hours making thousands of trades. They internalize many of the calculations they use to perform by hand, and they’ve developed razor-sharp discernment under pressure.
That’s also why we recommend joining a community where you can learn from the best and develop a long-term career as a short-term trader. As the adage goes, “if you want to go fast, go alone. If you want to go far, go together.” Real Trading is here to help you go far and make a great living doing it.
