Trading risk management
(part-1)

There are two important parts to manage risk while trading

You must have often heard option sellers claim that they have an edge over option buyers because, if the market either moves sideways or in their favor, they make money 66% of the time.

However, I would define market edge differently. We are in the stock market to make money. Therefore, an edge means that your system is able to produce more alpha than other traders. In simple terms, a system that gives you more profit than others. Mathematically, option sellers do not, or cannot, have an inherent edge over option buyers. This is because, while option sellers have a high probability of winning, they have a low reward-to-risk ratio. Conversely, option buyers have a low probability of winning but a high reward-to-risk ratio.

When we look at a trading system as a whole, it consists of:

1. Trading system

2. Risk management

3. Psychology

What happens is that discretionary option sellers are able to follow their system better because of the high probability of success. They have a psychological edge over option buyers.

Additionally, it is entirely possible to create a complete system, whether it involves option buying or selling, that combines decent probability with a good reward-to-risk ratio. Therefore, do not adhere to inherent thinking. Instead, try to innovate and create strategies based on your temperament (psychology), capital, time, and risk tolerance.

Profitability = number of trades x risk per trade x (reward ratio x win % - loss %)

Can we trade without stop-loss?

Yes.
Whole concept of stop-loss is to manage risk. So, SL is just a tool or method to manage risk.

So, what are the other ways to manage risk?

• Managing systematic risk through diversification

• Managing unsystematic risk through hedging

We will learn to manage these risk in next chapter.

F & Q

1.  Are stop-loss and position sizing important? Can we trade without using it?
   - Yes, stop-loss and position sizing are important but not every trader follow these rule.
   So, there are successful traders who do not use stop-loss but they also have their own strategy to minimize risk by doing hedging, diversification and adjustments. They know what to do when things go wrong.
   - One more thing if you have read strategy building course of ours. You will notice that stop-loss and position sizing are not independent concepts. They are part of trading strategy. So you will get the idea why people complain that stop-loss and position sizing is bad because they are not able to use it properly.