Managing risk makes or breaks a trader. Anyone who trades can immediately get blown away by a whirlwind of factors that not only affect the stock, but also their own thoughts and emotions. With this in mind, managing risk is the ultimate objective when becoming profitable. The first step is to focus on the factors that can be controlled. In terms of risk, the only equation you need to remember is:
In the market, what is easiest factor we can control? What is easier, increasing your income, or cutting your spending? Cutting your spending of course! The same mindset works with trading.
Trade with the Trend
As traders, we are our own weathermen. We must forecast how the market will generally behave in the near future in order to make a decision. The further we predict into the future, the less accurate our results will be. Therefore, the direction of a trend and the momentum a stock is our best reaction.
Recall our equation Wins-Losses = Profit (or Loss). Before we know we have won or lost, we must have plan for both scenarios.
1) Win: Where will I exit if my trade evolves favorably?
2) Loose: Where will I exit if my trade evolves unfavorably?
An scenario for good risk management:
You enter a stock at $100 share and expect a $10 gain at $110. Unfortunately, the trade behaved unfavorably and is now at $92. Fortunately, however, you had proper risk management. Because you were smart, you placed a loss exit at the $95 mark. This provided a Risk Reward Ratio of 2:1, and you only lost $5 on the trade.
Adjust Position as the Trade evolves
The simplest process involved one trade and one entry. However, as you gain more experience, you will notice that you can increase your probability whenever you enter the trade at multiple times.
As seen in the second picture, the techinque is to scale you entry and entering gradually as trade reveals itself. Instead of “reacting” to the market, you are adapting and evolving as the market moves. In either case, the goal would be to sell at the very top of the graph. The first picture would be perfectly fine for beginner, but if you want to decrease you overall risk, you must risk your capital based on how confidently the trade presents itself; as the trade moves, you move with it.
Ironically, exiting seems to be a hard concept for novice traders! However, much like scaling your entries, you can scale your exits. Taking all your profit at once may not be ideal, and whenever a trade moves favorably, you can take up to half of your profits, for instance, to guarantee your win. It’s better to seal the deal than to have a winning trade go sour.
NO Random Trades
Many times, when a stock is experiencing abnormal price activity, traders want to guess which way it’s going to go next. Picture a stock running from $2/share to $5/share in an hour. Some traders are quick to form a thesis such as, “it’s up too much so I’m going to short.” At that point, you may as well flip a coin.
You are better off waiting for the stock to form a trend so you can be on the right side of the trade.