“You’ve got to exercise control. Don’t get into a bitch fight over nothing. Don’t buy it.” – Wendy Rhoades, Billions
In Part 1 of our series in becoming a profitable trader, we outlined one of the most important (if not thee most important) part of any trade plan. The WHY.
Hopefully you have your fancy notebook dedicated to trading and you have your “why” written across the top of one of the first few pages. For the first month, come back to the “why” daily and read it over a couple times. You never want to lose sight of your goal in this endeavor.
Of equal importance, and related to your why is risk management. This is the topic for Part 2 in your quest to becoming a profitable trader.
Risk management is defined as the forecasting and evaluation of financial risks together with the identification of procedures to avoid or minimize their impact. There are entire job titles, departments, and even institutions related to the subject of controlling capital loss. In finance there is a designation offered by GARP (Global Association Of Risk Professionals) called the FRM.
Suffice it to say, controlling risk of loss is of paramount importance to any financial operation, and rigorous mathematics is involved in doing so. You being a brand new trader, likely of your own hard earned capital, are the head of the risk management department. It’s the most important title you will have in becoming a profitable trading operation.
No single blog post can even scratch the surface when it comes to teaching risk management. There is just too much to know. But, I can simplify this down to the basics (the very basics) for the aspiring trader by giving some simple rules that will serve you well when managing your money.
1. Planning the trade. As Chinese military general Sun Tzu’s famously said: “Every battle is won before it is fought.” The phrase implies that planning and strategy – not the battles – win wars. Similarly, successful traders commonly quote the phrase: “Plan the trade and trade the plan.” Just like in war, planning ahead can often mean the difference between success and failure. (Investopedia)
Before you ever decide to buy, you must first decide where your thesis is wrong should you begin to take heat on the trade.
Let’s say you are starting out with a $10,000 account for simplicity purposes. You are interested in getting long stock in $PAH, and old Bill Ackman holding and you plan to risk 5% of your total capital on this trade. ($500) The stock is trading at $10 even.
Before you even think about buying, you need to know at what price you will exit the trade on a no questions asked basis. It is $9? $8? Whatever it is, once that price is hit you will get out, emotionless, and accept you were wrong. Get used to it, you will be wrong a lot. I’m wrong all the time, I have no ego when it comes to my trades and neither will you in time.
Using the same example make sure that the simple money management risk / reward makes sense. You don’t want to own 50 shares of a $10 stock and set your stop loss at $8 and your profit target at $11. That’s a losing strategy. You’d want to get in a $10 stock with a stop loss at $9 and a profit target at $15. That is a winning system.
2. Cut losers early and let your winners run.
Continuing with our previous example of $10 PAH stock, here is a common issue I see all the time which causes new traders to fail. You get into your PAH long position and it begins to go against you. You thought you’d get out should it hit $9, and the stock is now trading at $8.25. You are sitting, waiting and wishing that it comes back to make you whole again. Bad idea. It rarely ever does, and if so it takes a long time and your capital is tied up in a bad trade where you could be using it elsewhere to make you money. Don’t let yourself justify or rationalize a loser. Cut it, get out and move on to the next idea. It’s simple but it’s not easy.
Here is what caused me to fail when I was new…
I’d get in $PAH at $10 and justify it as it traded below my mental stop to $8. I’d leave that losing trade on. Then, I’d go in search of another stock say FEYE which let’s say was also trading around $10. I get in FEYE and it trades to $11. I quickly take that gain right away because I get afraid that FEYE, my second position could start going against me. I book a $1 profit per share in FEYE while letting PAH trade down $2 or under. Then, I watch the winning trade I had on go to $20 per share and miss out on the upside.
Losing system.
There is an old market motto out there that says, “No one ever got hurt taking a profit.” That is precisely how most traders get hurt and ultimately fail. They take their profits too quick and are content to hold losers into the hole.
One of the basic tennants of Technical Analysis which I am a practitioner of is that once stocks begin to trend, they are more likely to continue to trend than reverse. In simple terms, if you get in a stock and it begins to work, let it. You picked a winner, good work now let it do it’s job.
3. The Percentage Game
Never risk more than X% on a single trade. This is going to differ based on your account size, and what you are trading. Stocks, futures, options, Forex, cryptocurrency, etc. Plan to risk no more than 5% maybe a bit more per position in the early going. Some may even claim that 2-3% is better. We want to keep emotion at bay in the early going. Wait until you see $1000 of your $10k account on the line the first time and you are down $200 or more. Unless you are cold and dead inside like I am, you will get emotional and make poor decisions with your trade.
4. Keep Number of Positions On Small
When starting out, you want to keep the number of positions on lower than if you have been at this a long time. Taking your entire account and putting in all in the market at once will cause you emotion, especially if we wake up to a big market sell off and all of your holdings are correlated to the indexes. I would recommend when getting started to keep a list of stocks you are interested in, but don’t trade more than 5 at one time.
Again, risk management is the most important duty you have as a money manager. No blog post can come close to fully explaining all you need to know, but you’d be surprised how far ahead you will be by following the 4 simple rules above.
If you want to boil it way down always come back to this: Focus first, second and third on what you stand to lose on the trade. Once you are comfortable with that, you can think what you stand to gain should the market go your way.
OC