RISK MANAGEMENT: YOUR PERSONAL LOSS PREVENTION PROGRAM
Why You Need to Manage Risk
Risk management is the science, and often the art, of limiting the losses your trading account may suffer. All professional and great traders lose money. What distinguishes the successful ones from the burnouts is that they manage their risk well.
There are two elements in risk management: a proper risk/reward ratio and position sizing.
A proper risk/reward ratio is defined by your entry, your profit target and your stop loss. New
traders think they need to trade with huge size to make significant profits. Although I take a large position at times when the risk/reward is in my favor, I know I need to be able to handle the risk. There is plenty of money to be made trading with modest size, especially in actively traded Stocks in Play. You can make a lot of money trading in and out of an active stock with small size. Likewise, you can lose a great deal of money trading in and out of an active stock with too big of a size.
Position sizing refers to how large of a position that you take per trade. Some trades are so obvious that you can take a huge position or, as some call it, “load the boat.” These setups are shouting, “Grab me by the face!” Some trading opportunities are attractive enough for a large position. In other trades, you just want to go for a taste and perhaps add more later. Learning when to have the most size is a skill that new traders must acquire. Poor position sizing leads to inconsistent results.
New traders often ask me how much size to take in a trade. This is not a helpful question. A more useful question is whether you can handle the size you are taking, regardless of how much buying power you have. Institutions and proprietary trading firms have significantly larger and deeper pockets than individual retail traders like us because they negotiate with a clearing firm to gain intraday buying power. While retail traders like us can only receive a 4:1 margin, a trading firm with a successful track record can obtain almost unlimited intraday buying power. They can, of course, offer as much buying power as they want to any trader within their firm – but they don’t. They have strict risk control rules, and each trader has a limited buying power to start. They slowly increase the buying power of their traders as they improve. More experienced traders have access to a larger buying power, and their profit offsets the losses of new and less experienced traders, to make their collective risk minimal.
Although I take a large position at times when the risk/reward is in my favor, I know I need to be able to handle the risk. When I take a large size and get a bad hit, I am able to recover. A bad loss right at the Open does not paralyze me. I am able to reassess my trading situation and continue trading.
Position sizing essentially depends on the type of stock you are trading. Medium float stocks make smaller moves in price and are therefore easier to manage the risk in during a trade. In contrast, for low float stocks that can move 10% or 20% in a matter of seconds, I never take a large position, even though their price is typically low (in the range of $1 to $10) and I have sufficient buying power for a very large position.
I suggest traders start with only 100 shares. One hundred shares is low risk, and although it’s a low reward, you need to start somewhere. When you are more confident in managing your emotions, you can increase the share size slowly. Develop your trading skills, build your trading account, and slowly increase your size.
My trade size depends on the price of the stock as well as my account size and risk management rules, but 2,000 shares is my recent usual share size if I am trading in the $20 to $50 price range.
For a more expensive price range ($50 to $100), I reduce my total share size down to 1,000 shares. I rarely trade stocks higher than $100. The more expensive stocks are less attractive to us retail traders and are often dominated by computers and institutional traders.
Three-Step Risk Management
Step 1: Determine your maximum dollar risk for the trade you’re planning (never more than 2% of your account). Calculate this before your trading day starts.
Step 2: Estimate your maximum risk per share, the stop loss, in dollars, from your entry.
Step 3: Divide “1” by “2” to find the absolute maximum number of shares you are allowed to trade each time.
For example, if you have a $40,000 account, the 2% rule will limit your risk on any trade to $800. Let’s assume you want to be conservative and risk only 1% of that account, or $400. That will be Step 1.
As you monitor a stock, you might, for example, see a situation develop where the Volume Weighted Average Price (VWAP) Strategy may very well work in your favor. You decide to sell short the stock at $50, and you want to cover them at $48.82, with a stop loss at $50.40. You will be risking $0.40 per share. That will be Step 2 of risk control.
For Step 3, calculate your share size by dividing “Step 1” by “Step 2” to find the maximum size you may trade. In this example, you will be allowed to buy a maximum of 1,000 shares.
In this case, you may not have enough cash or buying power to buy 1,000 shares at $50 (because you have only $40,000 in your account). So instead, you will buy 800 shares or, perhaps, even 500 shares. Remember, you can always risk less, but you are not allowed to risk more than 2% of your account under any circumstance.
BBT now has an equalized risk per trade script that is used in a hotkey to automatically define the number of shares you take based on the dollar amount or account percentage you want to risk on each trade. You simply click on the chart where you want your stop loss and you hit BUY or SELL (to short). The script will buy or sell the number of shares at which, if your trade reaches your stop loss, you will lose the pre-defined risk (e.g., $100). Therefore, you don’t need to worry about calculations in your head while you are watching multiple indicators and charts.
This innovative script was developed by BBT Member KyleK29 and is one of many practical illustrations of how effective a community of traders can be in sharing information, knowledge and experiences.
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- A Glossary of terms frequently used in day trading.
Would you like to ask Andrew Aziz some questions or share your own experiences? He would enjoy hearing from you at [email protected].