Context

I am a small caps trader that primarily focuses on scalping. I have been trading for roughly 3 years: I spent the first 1.5 years trading options in large/mid caps and the past 20 months trading small caps. (full time Jan 1st, 2022)

I use ThinkorSwim and Das Trader as my brokerage, and I have been ironclad in my risk management approach since day 1 of going full time.

Risk Management

I have categorized my risk management into 3 different parts that I will detail below:

• Having a Max Loss Stop out (also ways to calculate it)

• Sizing based on Sentiment (estimate sentiment for you strategy)

• Recovering from Drawdown

Max Loss: Over the past few years I have seen some of the most veteran traders have blowup days. I am not naïve to the fact that it could happen to me too. By implementing a daily max loss amount I have a set number that I am not allowed to ever cross and continue trading.

I choose my max daily loss amount by (add 30 most recent green days) then (divide by 30 to find avg green day) then (multiply by 2) = daily max loss. This gives me 2x my avg recent green day as a daily max loss.

I have found that this daily max loss amount gives me plenty of space to take a couple losses in a trading day while continuing to trade and not ever letting me lose more than a few days of progress (*tweak as necessary*). As you have bigger green days you will get a bigger number which means it fluidly adjusts with your recent trading performance.

As an added security measure I have seen some traders take 3x or 4x their avg green day number and set it as a broker max loss. (broker shuts off trading at that amount) So in a worst case scenario tilt where a trader ignores their daily max loss they can only ever lose a couple weeks of progress before their broker prevents a career ending loss.

Sizing Based on Sentiment: Another important part is the ability to adjust sizing to the market changes. No trader wants to be aggressive when the market is in a pullback or shorting during a bull market. This is very individual to each traders strategy, but I have found that 2 or 3 simple measures tracked together can save a lot of $ on the cusp of a shifting market.

Examples: Track # of A+ setups per week/month for your strategy; Track # of stocks you are watching above or below 100/200 sma/emas; Track $ volume amounts for top runners in your strategy; Track # of x% runners in a given timeframe; Track # of deep fades. (whatever you like/don’t like to see, track it)

The general idea is to build a data set that allows you to feel when the market is hot or slow for a given edge, allowing you early warning to speed ups or slowdowns.

Recovering from Drawdown: Arguably the toughest thing to do as a trader in the early parts of their career, having a plan to effectively recover from a drawdown and not become emotional is key to a long career in the markets.

My personal method is simple. After 1 day loss, size down half and take 2 days to recover. If I take 2 days of loss in a row, size down in half again (1/4 original) and take 4 days to recover. If I lose 3 days or more in a row it is likely there is a separate issue that needs to be addressed before continuing. (adjust based on loss size, tiny red day doesn’t equal half size, use discretion)

With this method even 3–4 red days in a row will cost you at most 2 normal sized loss days and after addressing whatever issue was causing the losses a trader can recover in 4–5 days rather than causing significant drawdown.

Conclusion: For my strategy and personal risk tolerance, limiting drawdown size and likelihood has highly benefitted my trading over the past 2 years. My emotions during trading are very dull compared to what they used to be which has caused a noticeable performance boost from when I first started.

It is important to note that these rules and strategies will only benefit a trader if he/she has the baseline discipline and respect to actually implement and reliably obey them. I believe that type of discipline starts outside of trading with diet, sleep, fitness, and overall life choices. But that is a whole other topic for another article…