Trades can go against us at any time. But if we know how to protect our working capital, the better off we are.
When you trade, think of yourself as a small business owner.
Small businesses have to worry about unsold inventory, the possibility of high staff turnover, potential fires and electrical shortages – worst case of course. To cut back on that possibility and to protect himself or herself, the owner cuts prices, has backup plans, and of course, insurance.
In other words, he’s managing the risk before disaster. He’s identifying risk beforehand, assessing the potential impact to the bottom line, and takes immediate action to safeguard in the event something happens.
As a stock trader, you do the same thing.
By managing risk associated with your portfolio, you increase your chance of increasing profitability, while decreasing your risk. Here are some key ways to do that. One, consider your stock position size.
No. 1 – Know your Risk Tolerance
Starting out, too many traders risk far too much money. They think the first stock they pick will help them retire early. But as we’re all well aware that’s never the case. So, we have to think smart about our risk tolerance level by asking ourselves, “Can I afford to lose $10,000 on a trade? If not, cut it in half, in quarters, in tenths.”
Think about allocation. Unless you’re Warren Buffett, you have a finite number of shares you can realistically buy. Some traders only risk 2% of their portfolio per trade until the trading account grows to a more substantial number. For example, if you have $5,000 in your account, you’d only risk $100 on a trade to start out.
Using this strategy, you make your money last longer than if you blindly invested.
No. 2 – Stop loss and Trailing Stop Orders
Defining your max downside is another imperative, or the most you’re willing to lose per trade. This helps remove emotion from your trade. If the stop is hit, you’re out – no questions asked. Without a stop loss, you have the ability to lose it all.
With stocks, we typically use a -25% stop loss. With options, we use a -35% stop. That way we cap potential loss, and remove emotion.
At the same time, we can employ the trailing stop loss strategy, too.
These allow for unlimited capital appreciation potential. As long as your stock or ETF keeps going up, the trailing stop will never get triggered. Meanwhile, your worst-case scenario is cut down to losing, at most, 25% (or whatever parameters you set the trailing stop loss trigger point out).
For example, if you buy a stock at the absolute high, the trailing stop will trigger when the stock or ETF is down 25%. It will be sold automatically. There’s no fretting. No getting stuck in a spiral of hoping something will come back. It removes all the costly emotions from the process.
No. 3 – Diversify
I’m sure you’ve heard this before.
But never, ever put all your eggs in one basket. You trip and fall, and all those eggs are broken… and you’re just about screwed. It’s easier to lose all your money if all of its in one stock. Spread the cash out and diversify in several names with several baskets.
No. 4 – Cut your Losses. Let your Winners Run
A lot of traders choose a target and take profits when the target is met. Others will allow winners to keep running, perhaps using trailing stops as we mentioned above.
They’ll also cut losses with stop losses to limit risk.
The best way to lose money in this market is to remain undisciplined. Have a plan. Stick with it. Don’t wait on losers… and you’ll be fine.
Also, remember that a win isn’t a win until the gain has been taken. If it’s still in your account as an open position, you haven’t banked it yet. If you see a good gain, take it off the table and don’t get greedy.
No. 5 – Remove emotion from your trade
Remove all emotion from your trading. That doesn’t mean you have to have ice flowing through your veins. It simply means you need to re-think your strategy. No matter what your emotion says, never allow emotion to dictate your trading action.
Bottom line, good trading isn’t about picking the right stocks.
Any one can do that. Trading successfully involves using proper risk management.