Effective implementation of stop-loss orders and risk controls is fundamental to preserving capital in algorithmic trading. While sophisticated models and backtesting frameworks can identify profitable edges, markets are inherently uncertain, and even the best strategies can incur losses. Without clear rules to curtail losses when things go awry, a strategy that looks robust on historical data can bankrupt an account in live markets. In this chapter, we examine four core types of stop-loss and risk controls—hard stops, soft stops, trailing stops, portfolio-level stops (often called circuit breakers), and time-based exits—exploring their theoretical underpinnings, practical implementation considerations, and illustrative examples with step-by-step calculations.

Position sizing and capital allocation represent the twin pillars upon which profitable and sustainable algorithmic trading strategies rest. Even a system with an excellent edge can falter catastrophically without proper control of how much capital is risked on each trade and how total capital is apportioned across multiple strategies. This chapter explores four foundational approaches—fixed fractional and fixed dollar sizing, the Kelly Criterion, volatility‐adjusted sizing, and the trade‐off between diversification and concentration—illustrating their theoretical underpinnings, practical implementations, and real‐world examples.

Drawdown (Max, Average) Definitions and Concepts

Definition and Overview Market risk—often called “systematic risk”—refers to the potential for losses resulting from changes in market prices and rates (Hull, 2018). In the context of algorithmic trading, market risk encompasses unfavorable movements in asset prices, interest rates, foreign exchange rates, and commodity prices. Market risk is distinguished from idiosyncratic risk (or “unsystematic risk”), which arises from firm‐specific events (e.g., a CEO scandal, product recall). Because idiosyncratic risk can be largely diversified away, market risk—affecting entire sectors or the broad market—poses the greatest threat to portfolio value.