Successful traders understand the importance of risk management. Trading is inherently risky because it is a zero sum game. Every dollar you gain through trading represents a loss on someone else’s balance sheet. Traders win and lose in the financial markets every day. The difference between successful and not-so-successful traders is understanding and applying a simple risk management strategy.
While risk management is a broad topic, it means one thing for our purposes here. Namely, to “cut your losses early.”
Write it down and put this phrase somewhere near your trading station. It is literally the difference between making a nice income from trading and from losing your shirt.
A losing trader has no trading plan. He hears about a stock that is destined to go up in value so he buys. Then the stock tanks about 10% and then he buys more. After all, now its on “sale” right? Then, the price goes down even more and the losing trader buys even more. This guy is literally paying for his ticket to the poorhouse. He clearly has no business trading stocks because he is aimless in his pursuits.
Pride is the number one reason that traders lose big money in the markets. If you can learn early in your trading career to admit when you have a loser on your hands and sell, you can go far. If a stock trade doesn’t work out the way that you had planned, sell the stock. There is nothing wrong with losing money on a trade. It happens everyday. Instead, view your losses as your “tuition” on Wall Street. Learn from your mistakes and try to avoid repeating them.
Know Your “Exit” Before You “Enter”
Successful traders create their own risk management strategy by determining up front how much money they are willing to lose on each given trade. In other words, before you place a trade to buy a stock, you need to set your maximum risk. Are you willing to lose 50% if the stock goes south? I hope not. That’s another sure ticket to the poor house.
Here are some of the most common questions that I received over the years from new traders. My answers are always the same.
Q: So how do you know when its time to sell a stock that is falling in price?
A: This is a question that only you can answer because everyone has a different tolerance for risk.
Q: How do you decide your exit in advance of your entry?
A: By creating your own pre-determined set of risk management rules.
Q: How much of a loss should you take before you decide to liquidate your position within a stock?
A: It depends upon your purpose for the trade and your tolerance for risk.
My point is simple: You must own your success and your mistakes. Other people do not get to tell you when to sell. As a trader, that is your domain. As you can see, there are no hard and fast rules on these matters.
To me, “cutting your losses early” means just that… early. I don’t like to lose money and my tolerance for risk has decreased over the years. Therefore, my experience and my preferences impact my definition of that word “early.” And while I cannot tell you what your risk management strategy should be, I will share mine with you. Perhaps you can take mine and use it as a template to formulate your own risk management strategy.
My Personal Risk Management Strategy for Trading
So how do I define the word “early” when it comes to cutting my losses?
I have a two-fold approach, one for my short-term trades and another for my longer trades.
Short-term trades: When it comes to day trading, overnight trading, trigger trading, and extremely short swing trades, the absolute maximum loss that I am willing to incur is capped at 5%. And while 5% is the absolute maximum, I usually place my initial stop-loss order at 2%-3%. In fact, it is rare that I will risk my maximum 5% on a short-term trade.
For example, if I place a short-term trade on a stock priced at $10, the most that I am willing to lose on that trade is $0.50, or 5%. I would do this by placing a stop-loss order for the stock at $9.50.
Longer-term trades: When it comes to swing trading, position trading, and micro-cap investing, the absolute maximum loss that I am willing to incur is 10%. And while 10% is my maximum risk threshold, I typically place a stop-loss order of 7%-8% on longer-term trades. It is rare that I will risk my maximum 10% on a longer-term trade.
For example, if I place a short-term trade on a stock priced at $10, the most that I am willing to lose on that trade is $1.00, or 10%. I would do this by placing a stop-loss order for the stock at $9.00.
These are my rules based upon my experience, my total trading capital, my knowledge of the markets, and my risk tolerance. Some traders I know take more risk, and others less. The only one who can decide what your risk tolerance should be is you.