Risk management is not the most exciting topic in trading, but it is the most important. You can have a strategy with a 70% win rate and still go broke if you size your positions recklessly. Conversely, a strategy with a 40% win rate can be highly profitable with proper risk management. This lesson covers the concepts that keep you in the game.
Concept: Position Sizing
Position sizing determines how much you risk on each trade. The standard approach is to risk a fixed percentage of your account on every trade — typically 1% to 2%. This means if you have a £10,000 account and risk 1%, you can lose a maximum of £100 on any single trade.
Your position size is then calculated from your risk amount and your stop loss distance. If you are risking £100 and your stop loss is 50 points away, your position size is £2 per point (£100 divided by 50). This simple calculation ensures that no single trade can cause catastrophic damage to your account.
Risk Per Trade: The 1% Rule
The 1% rule is the foundation of retail risk management. By risking only 1% per trade, you can endure a run of 20 consecutive losing trades and still have over 80% of your account intact. That gives you room to recover. Risk 10% per trade, and five losses in a row halves your account — recovery from that is extremely difficult.
Some experienced traders push to 2% per trade, and a very few go as high as 3% on their highest-conviction setups. But until you have a proven track record over hundreds of trades, stick to 1% or even 0.5%. Survival is the first priority. Profits come from surviving long enough for your edge to play out.
Maximum Drawdown
Drawdown is the peak-to-trough decline in your account. If your account grows from £10,000 to £12,000 and then drops to £10,500, your drawdown is £1,500 or 12.5% from the peak. Maximum drawdown is the largest such decline over the life of your account or strategy.
Set a maximum drawdown limit for yourself — many professionals use 10-20%. If your account drops by that percentage from its peak, stop trading and review everything. Something is wrong — either the market conditions have changed, you are not following your rules, or your strategy needs adjustment. Continuing to trade through a deep drawdown is how accounts get destroyed.
Risk of Ruin
Risk of ruin is the probability of losing enough money to stop trading. It depends on your win rate, your average win relative to your average loss, and how much you risk per trade. A trader with a 50% win rate, 1:2 risk-to-reward, and 1% risk per trade has a near-zero risk of ruin.
Change that to 10% risk per trade with the same win rate and the risk of ruin skyrockets. The maths is unforgiving. Your edge does not matter if you size your positions so aggressively that a normal losing streak wipes you out before the edge has time to work.
Example: Kelly Criterion Simplified
The Kelly Criterion is a formula that calculates the theoretically optimal bet size based on your edge. The simplified formula is: Kelly % = W - (L / R), where W is your win rate, L is your loss rate (1 minus win rate), and R is your average win divided by your average loss.
Say you win 55% of trades (W = 0.55, L = 0.45) and your average winner is 1.5 times your average loser (R = 1.5). Kelly % = 0.55 - (0.45 / 1.5) = 0.55 - 0.30 = 0.25, or 25%.
Full Kelly is extremely aggressive and assumes perfect knowledge of your edge. Most traders use "half Kelly" or "quarter Kelly" — so in this example, risking 6-12% per trade. Even that is aggressive for most people. The Kelly Criterion is useful as a theoretical ceiling: it tells you the absolute maximum you should consider risking. In practice, most retail traders should stay well below it.
Warning: The Maths of Recovery
If you lose 10% of your account, you need an 11% gain to get back to breakeven. Lose 20%, you need 25%. Lose 50%, you need 100% — you have to double your remaining money just to get back to where you started. Lose 75%, you need 300%.
This asymmetry is why risk management matters more than anything else. It is far easier to avoid large losses than to recover from them. Protect your capital above all else. There will always be another trade tomorrow — but only if you still have an account to trade with.