## Options Education

Risk is one of the most important parts of trading that we must master if we are to have a long consistent trading career. A popular saying in the markets is, "Take care of your losses and the winners will take care of themselves." Unfortunately, this is often overlooked by the masses as the statistics of successful trading are rather low. At Online Trading Academy, we emphasize good risk management as much as we show our students core strategies to give them a better chance of success so as not to become one of these statistics.

Many traders start out investing in the stock market with a cash account. This is very beneficial because in a cash account you can only lose the amount you have in your account. With a leveraged account, as in the Futures markets, you can lose more money than is actually in your trading account. For example, if the mini-S&P is trading near 1200.00, then the contract is valued at \$60,000. As Futures traders, we are currently required to have \$5,000 per contract in our account to hold a position overnight. This means there is a \$55,000 difference and we as traders are technically responsible for any portion of that amount. With today's technology and risk servers at the Futures Commissions Merchants (FCM) where our funds are deposited, the odds are low for having to pay the full contract value, but then again, anything is possible with the chaos in the world today.

In this article, I wanted to show you how you can adjust your entry to meet your risk tolerance so you do not take more risk than your account can handle. Keep in mind that if we take 20 ñ 25% risk, we only have to be wrong 4 ñ 5 times before we blow up our accounts. This could mean if you wanted to replenish your trading account after losing all your money, you might find yourself hanging out a drive-through window in February asking, "Do you want fries with that?"

Figure 1 will represent a Sugar chart with a supply zone. Let's say you have narrowed your supply zone range down to about as small as it will go and you are faced with a risk of .22 ticks (A ñ B = C) - Sugar is \$11.20 per tick. We must also allow for our stop placement in this range so we will put it 2 ticks over the high of the supply zone. The risk is now .24 ticks, or \$268.80 per contract.

Figure 1

If we use the entry price of 26.10 and place our stop at 26.34, this could present a problem for the trader if their account size is \$10,000. Risking \$268.80 is approximately 3% of their account size. Let's say our trader is using a 1.5% risk tolerance to trade with, or \$150. If the trader is to stay within their risk tolerance, which I hope they plan to do, then he must use this \$150 stop. "But you said his risk was \$268.80, how is he only going to risk \$150?"

Figure 2 will illustrate how we can actually use a 1.5% stop instead of breaking our risk management rules and using a 3% stop.

Figure 2

Originally, we were going to enter this trade at the bottom of the supply zone. However, we are great risk managers and have decided to reduce the risk to our own personal tolerances. When using this strategy to reduce risk, the one thing we cannot change is where the protective stop price will be. We must keep that at its original location or else we stand the chance of putting it too close to current prices and getting stopped out. This requires us to simply subtract our 1.5% (13 ticks) from the actual stop price that will prove us wrong. Our new entry price will now be 26.21 and our stop is at 26.34. This is how we get a 13 tick stop that fits our risk parameters instead of using the original stop of 24 ticks (3%). Notice how the price came into our zone and actually filled our price. Then just like any good supply level, the price dropped. By reducing our risk, this also increases our risk/reward ratio nicely. For example, by having smaller stops, you can try for 1:5 risk/reward and have a better chance of obtaining it. If your stop is much bigger, then your reward has to be in relation to that, forcing prices to travel further before you exit.

Of course, there is a drawback to using this risk management style. What if price does not come back into the zone enough and you miss your trade? My response to you would be, "So what?!" I would much rather see traders miss a trade that fits their risk tolerance than to take a trade with too much risk.

These charts are of sell setups; you can reverse them for the buy side. To do this, we would add 1.5% (or our own risk tolerance) of our account to the protective stop. Instead of entering the market at the top of the demand zone, we would then wait for price to come to us and give us superior risk management.

By always managing your risk first, you will have a much better chance of surviving as a trader. One of the first things I look for when I enter a trade is where I am wrong (my stop). This is the only thing I can control other than my entry price. There is no way I am going to make the market go to my profit objectives so I must first manage what I can control. Then I can attend to setting profit objectives.

"If things go wrong, don't go with them." Roger Babson

Trade the risk and then the profits, Don Dawson
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