A Good Risk Management System Makes Money
This is a tutorial on risk management also known as money management. This is perhaps the most important part of learning to trade stocks, commodities, futures, Forex, or any other financial instrument. THIS IS THE SECRET TO TRADING SUCCESS. Many traders learn all the aspects of trading except risk management. Understanding risk prevents you from destroying your equity, and allows you to take the largest trade WITHOUT jeopardizing your total account value. Without risk management you are literally gambling. A few COMPLETE risk management systems will be revealed. While many websites are vague in describing exactly how to manage risk, you will find that all that is needed to be learned can be found here. Tools of risk management will be discussed below.
Make Selling Automatic
Use Stop Loss Orders: This is an order placed with your broker to sell at a predetermined price. This is used to prevent further losses on a position should the trade start losing money. For example, if you bought Netflix stock at $70, right after buying you would put in a “stop loss” order to sell at $63. If the stock falls at or below $63, your shares will be sold at the prevailing market price. The stop loss PRICE should be defined through technical analysis, a support or resistance level, moving average, or volatility stop.
The advantage is you don’t have to constantly monitor the stock price. Using this risk management method while you are on vacation, or at work, or tending to other things, will automatically exit the trade and sell if the market turns against you.
The disadvantage is the stop loss can be activated by short term fluctuations in the market. You will hear traders get whipsawed, when their stops get hit then the price continues upward causing the trader to miss the upward move leading to profits. This can be the most frustrating thing for those who are inexperienced at using stop loss orders. News, earnings reports, and market commentary can cause price action to get volatile at cause a stop to get activated. The key is picking a stop-loss price that that gives room for market volatility. Placing a stop loss is an art in itself , and we will go further into detail about this risk management strategy.
Lock In Profits Automatically
Trailing Stops: Stops aren’t just used to minimize losses. It is also used to lock in profits as the stock price climbs and produces profits. When a trailing stop is placed and the stock price fluctuates upward, the stop automatically adjusts to lock in profits. For example a 10% trailing stop will initiate a sell order if it exceeds 10%. Say Microsoft’s stock price climbs to $30. The stop will be moved to 10% below $30 in which it will activate a sell order. Say, two days from now Microsoft stock climbs again to $35, the trailing stop automatically adjusts to sell 10% below from $35 and so on. As the stock climbs, the stop trails behind and follows the price action locking in profits. Remember these risk management strategies are to make life easier for the active stock trader. Get to used to using these methods at all times when trading stocks.
Disadvantage: When a stock starts to trend, volatility increases, aka the fluctuations. Especially in a violent uptrend. As the stock starts to climb, you may get stopped out prematurely. We overcome this by manually trailing the stop according to volatility using a “Volatility” stop. This method is much better and allows us to adjust so we don’t sell out prematurely. For the sake of Breakout Theory, we WILL NOT use a “trailing stop” but we will “manually” trail the stops ourselves. It requires just a little more work and not entirely automatic like a trailing stop.
Your Bet Size Must Be the Same For Every Trade
Position Size: Can be described as the size of the trade, or how many shares you will buy. This is determined by an exact value based on how big your account is, and where your stop is. You want to bet large enough to make money. Taking a large position will destroy you if it’s too big. Taking a small position will yield small or insignificant. There is a sweet spot. You take 2% risk. The Rule of Thumb: You will not risk more that 2% of your total value of your trading account. This is calculated by determining where your stop will be, and calculating what 2% value of your trading account is. Then calculating if a stop were to get hit and sell the shares at a loss, that loss will not be greater that 2% value of your trading account. For example if your total account value is $10000. Then risking 2% would be $200. ($10,000 x 0.02 = $200). Thus, when your stop gets hit, your loss will not greater that $200.
IMPORTANT NOTE: $200 is NOT the position size, it is the risk in dollar value. 2% risk is $200 risk based on $10,000.
How To Calculate Your Bet Size / Position Size
Position Size is as follows:
-Say you determined the Breakout Price/Buy price for Microsoft to be $31
-Using technical analysis you have determined the Stop to be at $27.28
-The distance from $31 to $27.28 is downward move of 12%
- $31 minus $27 equals $3.72, then divide by $31, giving you 0.12 or 12%
- In equation form: ( $31-$27.28) / 31 = .12 = 12%
-Then, $200 divided by .12 = $1666.66 <<<THIS IS YOUR POSITION SIZE.
-You are allowed to buy $1666 worth of Microsoft stock.
How Many Shares will you Buy
-We know that the Breakout / Buy price is $31. So $1666 divided by $31 a share equal 53 shares.
- In equation form $1666/$31 = 53 shares. THIS IS YOUR POSITION SIZE IN SHARES
Always Calculate The Losing Scenario
Let’s look at it as a Trade that went bad:
-You Buy 53 shares @ $31 which would equal $1643.00
-Stock drops to $27.28 and you are stopped out. You sell 53 shares @ $27.28. You get $1445.84 back.
-$1643-$1445.84 = $197.16 loss on this trade
-This loss is about 2% of your account value.