Risk Management 101

11 - Incorporating Risk Management in Mechanical Systems


For some traders, the idea of having to think about risk management for every single trade can be tedious. This is why some traders opt to incorporate risk management rules in mechanical trading systems, which can automatically calculate stop losses and position sizes.

Mechanical trading systems have gained in popularity, as these can be capable of reducing the effect of human emotions in trading. It simply makes use of technical indicators set at pre-determined parameters and complying with entry and exit rules to generate trade setup signals.

More often than not, stop losses are also based on hard numbers or the volatility of the pair being traded. In some cases, stop losses can be based on technical indicators as well. For instance, some systems set an initial 50-pip stop or one that allows the trader to close the trade when a new crossover takes place.

This way, mechanical system traders no longer need to take a few minutes to map out their risk management decisions for every scenario of price action. Not only does this prevent human emotions of fear or greed from interfering, it also saves time for the trader.

This has given rise to the development of algorithmic trading systems, which are constructed using computer codes that can execute trades right on the platform without the trader having to constantly monitor price action. Of course this takes time and knowledge to develop, although the process can be outsourced to freelance programmers.

If you are interested to create your own system, you can start with figuring out which technical indicators you are most comfortable trading with. Note that it is not imperative that you know how these indicators are calculated, but it is important to have a basic understanding of what it reflects and how it helps predict price action.

From there, you can look at the time frame you'd like to trade. If you are comfortable with several trades being entered and exited in a short span of time, you can work with a scalp trading system on the 5-minute or 15-minute charts. If you'd rather stick to longer-term price action and would rather have few trade signals every now and then, using the daily or weekly time frames might work. Or if you're a mid-term trader, you can set your indicators on the 1-hour to 4-hour charts.

You also have to be able to decide if you want a trend-following or mean-reversion system. Moving averages are generally used for most trend-following systems yet the concept of mean reversion is applied using the oscillators. Again, what matters is that you are knowledgeable of the technical indicators you are using and that you are able to make adjustments if necessary.

Entry and exit rules must also be determined, and this can be based on hard numbers such as a 50-pip stop and 100-pip target for instance. You can conduct back tests and forward tests in order to figure out the optimal number for these exit points, so that you can also base your risk management rules on these as well.