Your mindset provides you with a strong opportunity to hedge yourself against risk in your trades, but it is not the only way that you can protect yourself. You also need to make sure that you are protecting yourself in practical ways against risks in the market so that you are taking advantage of all of the tools available to help you succeed.  

When it comes to trading, you can never be too careful, and you should always be exercising every technique possible to protect yourself against risks in the market.  

Protecting Through Diversifying  

One of the best things you can do to protect yourself when you are trading is to diversify your portfolio. Diversifying your portfolio means that you are investing your capital into multiple different trade deals so that you are invested in several different areas. The reason why diversification hedges you against risk is that it prevents you from the likelihood of total losses. 

In this case, if one of your trades does not perform well, another one of your trades is likely to outperform it and make up for that loss. As long as you are doing your best to research every single trade and trade with confidence, you are likely to see success in many of your trades if you use this strategy, and the losses you do see will not be nearly as catastrophic.   

People who want to earn a serious profit with trading are virtually always invested in multiple deals at once to ensure their success, as this increases your potential for maximizing profits, as well.  

When it comes to diversifying, there are three ways that you can do it. The first way is to become involved in multiple trade deals that are all fairly similar in nature, for example, getting involved in multiple different options trades.  

If you are brand new to trading, it is advisable that you use this diversification style first and that you master trading options before you move on to any other form of investing or trading. This way, you are able to develop your confidence and skill in options first before venturing off into a new trading strategy.  

The other two types of diversification that you can engage in with trades include diversifying with non-correlating assets and diversifying your risk category. Both of these are going to help you limit your risk while also improving your money management skills, which will ultimately help you become a smart and successful trader.   

Diversifying Your Risk Category 

The other way that you can and should diversify your portfolio is through diversifying your risk category. When it comes to trading, there are three risk categories that you can fall into including conservative, moderate, and high. Conservative trades allow you to guarantee a profit from your gains, however, the amount being guaranteed is often very small and does not generally have room for significant growth.  

Moderate trades do carry a higher risk with them; however, they also earn you bigger profits in the long run. If you trade moderately, a strong trading strategy can help you succeed with those trades which will increase your chances of securing your profits. High-risk category trades are those that have a high potential to fail, but if they do succeed they will carry massive profits with them. These tend to be the most stressful investments because of how large the risk is, but if they go through the returns you get can be huge.  

Generally, every trader has a risk category that they tend to stick to with most of their trades. This category will likely fluctuate as they grow older, as the older you get, the more you are going to need to have your profits available for you to use, and the less time you will have to recover from any losses you incur in your trades. For this reason, it is advised that you actually use your age to help you determine what risk category you should be trading with when you are making trades.    

The easiest way to determine your category is to subtract your age from 100. The value of your age should be the percentage of your funds invested into conservative investments, whereas the value remaining is free to be invested in moderate or high-risk investments. Ideally, you should further apply this rule to decide which percentage should be invested in moderate risk versus which should be invested in high risk, so that your money is always being invested in a way that is appropriate for your age.  

For example, if you are 25, then 25% of your overall investment capital should be invested in conservative investments. Then, 25% of your remaining investment capital should be invested in moderate investments, with your other 75% being invested in high-risk investments.    

If you are 60, then 60% of your overall investment capital should be invested in conservative profiles, and 60% of your remaining investment capital should be invested in moderate investments, and the rest can be invested in high-risk investments. You can always adapt your chosen strategy based on what you feel your needs are and what level of risk you are willing to incur but using this as a guideline is a great way to ensure that you are managing your money properly.  

This way, you are able to maximize your profits while also ensuring that the capital you need will be accessible when you need it at any period in your life.  

Diversifying With Non-Correlating Assets  

Diversifying with non-correlating assets is a strategy that you can execute almost right away when you begin trading options. The key to this diversification is that the underlying assets that you are trading are different from all of your trades. For example, some of your trades may involve assets such as bonds and ETFs, whereas others might include commodities and currencies.  

By changing the underlying assets that are being traded, you hedge yourself not only against fluctuations in the specific stock that you are investing in but also in the industry that this stock is a part of. In this case, if the industry itself takes a hit, you are not at risk of having every single trade deal you have made suffer due to it. Instead, you can feel confident that a strong portion of your portfolio remains unhindered from that fluctuation and you have no reason to panic.  

If you want to take this a step further, after you have grown confident in options, you can begin to diversify your trading style by investing some of your funds elsewhere.  

I will not elaborate too much into this as it is not relevant to swing trading with options, however, do understand that it can protect you in your investment portfolio overall while also giving you the greatest earning potential with your capital.  

The 5% Risk Account  

Some people think that a trade deal should only include the capital that was required to buy into that trade deal including the cost per share and the commissions that you pay to the brokerage to make your deal. While it is true that this is the only money you require to get involved in a trade, it is not true that it is the only amount that you should set aside for a trade.  

If you want to manage your money effectively and hedge yourself against risk, you should always invest 5% of a total investment amount into a “risk account.” This account ensures that you have enough capital to recover the losses should one occur, enabling you to carry on trading. Without it, you might find that some of your losses have catastrophic impacts on your bottom line and significantly reduce the number of trades you can afford to engage in actively, which directly damages your profitability.  

Keeping that risk account open with 5% of your total investment capital (or more if you are engaging in riskier trades) will ensure that you are protected and that you can continue to make trades even if you experience a loss.  

The 2% Rule Of Money Management 

In addition to ensuring that your portfolio is diversified with different investments and risk categories, you also want to make sure that you are managing your capital with each individual trade that you make. Ideally, you should never be trading more than 2% of your overall investment capital into any single trade. So, if you have 5000 to invest, you should never be investing more than $100 into any given bare bones.    

This ensures that you are diversifying your portfolio enough to protect yourself against risks while also increasing your likelihood of gaining profits from each trade. If you trade more than 2% of your investment capital into any given risk, you massively expose yourself to losses which can devastate your portfolio and your investments.  

Realizing this rule and putting it to work in your own trading portfolio might seem overwhelming early on when you are brand new to trading. You might find yourself concerned that you will not be able to effectively manage all 50 trades, which is a reasonable fear when it comes to starting out as a trader. Understand that enacting this rule does not mean that you are obligated to get started in 50 different trades all at once, effectively overwhelming yourself with attempting to manage them all. 

Instead, you can start with managing just 1 trade, and then increase to managing 3-5 trades, and then continue increasing until all of your investment capital is sunk into different investments.  

Gradually increasing the number of trades, you are involved in will not only help you grow used to managing all of these trades, but it will also prevent you from becoming fearful or overwhelmed and making emotional trade deals. Early on, it is perfectly okay to start small and build your way up as your confidence grows, as this can be a powerful opportunity to increase your success in trades.  

Keeping 30% Of Profits  

When you begin trading, it is important that you always keep a percentage of the profits that you are earning from each trade deal. It might feel like a good idea to sink all of your profits back into your trades and profit even more but trust me when I say this is not the best idea. Investing all of your profits back into trades can make trading feel fruitless and can actually work against your desire to stay committed and persistent with your trades.  

With all of the effort that you are putting into making those profits happen, if you are not at least sometimes rewarding yourself by cashing out on some of them so that you can experience the tangible benefits, it might begin to feel pointless.  

If you are trading as a way to increase your capital and not as a way to replace your income, you might only want to keep 10-25% of your overall profits for yourself in your trades. This capital should be put toward fulfilling the goal that you outlined before you began investing, such as setting aside money to buy a house or paying off debt. This way, you are achieving your purpose with trading while continually investing even more into your trades so that you can do even more in the future.   If you are trading with the intention of replacing your income entirely, you want to use the right strategy to get there so that you can comfortably leave your job while still having enough to afford the cost of living. In this case, you would want to cash out about 30% of your overall profits from each trade and apply that toward your cost of living.

Options trading can be a great way to make money, but it comes with its own set of risks and rewards. Options trading is not for everyone, but for those who are willing to take the risks, it can be a profitable venture.

Options Trading Risk

Like any other investment, options trading carries its own set of risks. Here are some of the risks associated with options trading:

1. Limited Timeframe – Options have a limited timeframe, typically ranging from a few weeks to a few months. This means that if you don’t make the right move within the given timeframe, you could lose your investment.
2. High Volatility – Options trading can be very volatile. This means that the price of the underlying asset can fluctuate rapidly, making it difficult to predict the outcome of your trade.
3. High Risk – Options trading is considered a high-risk investment. This is because the price of the underlying asset can fluctuate rapidly, and the value of the option can decrease quickly.

Options Trading Reward

Options trading can be a very rewarding venture if done correctly. Here are some of the rewards associated with options trading:

1. High Returns – Options trading has the potential for high returns. This is because options trading allows you to leverage your investment, meaning you can control a larger amount of the underlying asset with a smaller investment.
2. Flexibility – Options trading offers flexibility in terms of the underlying asset you can trade. You can trade options on stocks, commodities, currencies, and more.
3. Hedging – Options trading can be used as a hedging strategy. This means that you can use options to offset losses in other investments.

The Importance of Effective Money Management

Money management is only included in the trading plan by about one-tenth of all private traders. Just because a trader does not have a lot of capital does not mean that he cannot apply the principles of money management. Many traders are of the opinion that these ideas can only be used by large asset managers and institutions. 

Money management also implies that the potential risk, taking into account the preferences of the trader, is set in relation to the expected profit. The goal is to set a desirable yield rate and then minimize the associated risk.

Trading generally requires four decisions:

• Buy/sell (system or strategy)?
• Which security is traded?
• How many contracts or shares of value are traded?
• What is the share of capital risked on a trade?

The first decision is about the trading process itself without taking into account money management. The other three decisions involve maximizing profit and minimizing risk directly. The foundations of risk and reward should be considered from the start in the development of a trading system and must become an integral part of the system.

If a trader works profitably right from the start and has thus increased his trading capital, then he cannot be ruined by four losses (as long as his bet remains the same). Although the number of consecutive losses that would lead to ruin increases with time, so does the likelihood of multiple losses follow one another. The following formula calculates the probability of ultimate ruin (WR) over time:

WR = (1-VT / 1 + VT) AH

VT stands for the trader’s advantage (percentage winners – percent losers), and AH is the initial trading units. If the initial capital of a trader is $ 20,000 and his bet per trade is $ 5,000 then AH = 4. The following example calculates the probability of ultimate ruin:

Total Capital§ 20,000  Total Capital$ 20,000

Deployment$ 5,000    Deployment§ 2,500

Advantage of the Trade10%   Trades’ Advantage10%

Chance of Ruin44.8% Chance of Ruin20.1%

Total Capital$ 20,000  Total Capital$ 20,000

Bet$ 2,000       Bet$ 1,000

Advantage of the Trade10%   Advantage of the Trade10%

Chance of Ruin13.4% Chance of Ruin1.8%

These numbers apply only when you trade one contract at a time. With changing contract numbers, the risk of ruin changes dramatically. Moreover, these calculations assume that, in the case of a profit, the amount is always the same and corresponds to the loss in the negative case. As mentioned above, the risk of ruin is determined by the percentage of winners, the ratio between winners and losers, and the size of the bet. So far, we have disregarded the relationship between winners and losers. In real life, most successful trading systems score less than 50% winners and win-loss ratios above 1.2. 

The risk of ruin is an interesting indicator, but it does not give much insight into how to use or manage capital efficiently. For self-preservation, it is best not to put everything on one card. If you choose your bets well and follow a system with a positive bias, the risk of ruin is very low.

The Capital Allocation Model

Now you know the tools you need to understand our capital allocation model. First, we’ll show how capital is allocated to a one-market portfolio using a small selection of data.

As you know, our goal is to maximize profit while minimizing risk. This goal must be achieved without exceeding the limits of justifiable risk. To reach the goal, we need to know how much capital is to be allocated to each market and what number of contracts should be traded. In this model, capital is calculated from the market value of the account, the average monthly returns, and the market risk. The market value is simply the starting capital with which we begin our trading. In these examples, the returns do not add up; we use the initial capital for all calculations. The average monthly income is the capital that we can expect to gain from our system. Market risk is the amount we can lose per day on a trade. Asset managers use a variety of metrics to assess market risk:

•      Mean Range: The average of the ranges of the last three to 50 Days, which is converted into a monetary amount in US $. For example, if the average spread is 40 points for the Swiss franc over the past 10 days and the Swiss franc is $ 12.50, the market risk is $ 500. The likely amount of market movement is the average spread of the last x days. This does not always have to be right, but the capital allocation model needs to be built on certain probabilities.

•      The average change in closing prices: The average change in closing prices over the last three to 50 days says more about the risk, as this value indicates the expected risk if the position is held.

•      Mean change in positive closing prices versus negative closing prices: the average change in the negative closing prices over a period suggests the risk of holding a long position.

•      The standard deviation of closing prices: The standard deviation of the closing prices gives a more accurate picture of the risk, as the daily deviation is displayed with a probability of 68%. This calculation is a bit more complex, but it does not cause any problems with the computers available today.

In whatever way we measure the risk, it is the most important variable to watch and the most important component of the capital allocation model.

A Market Portfolio

Whether the system trades futures or stocks makes no difference. Before we can allocate capital, the average monthly income and market risk must be determined on the basis of a contract. We also need to determine how much of our capital we are willing to risk per trade. But we cannot know that yet, because that’s exactly what we want to find out. 

Cumulating Of Results

Cumulating means here the process of capital allocation based on the current portfolio or deposit value. The current portfolio value results from the start-up capital as well as the already completed positive and negative trades. When it comes to large sums of money, accumulation is very good: the capital invested increases or decreases depending on the current value of the deposit. If a trading plan is successful, then each trade will be given more capital; but if it is bad, then there is less capital available for each trade. Note that we have found that cumulating is very good when it comes to large sums. This limitation stems from the belief that the allocation should not be extended until the seed capital of smaller accounts has not been at least doubled or tripled. Even good systems can crash after a series of wins, and if a smaller account does not cumulate, there is still some capital left for bad times. If accumulation is of interest to you (and it should, if you have significant sums of money), then you can build it into the capital allocation model with a small change. In the formula, do not use seed capital as total capital (GK), but use the current value of the deposit.