Stocks Trading Risk Management
Differentiating Survivors from Quitters
“If you have an approach that makes money, then money management can make the difference between success and failure… … I try to be conservative in my risk management. I want to make sure I’ll be around to play tomorrow. Risk control is essential.” – Monroe Trout
Trading is about making money, and it is equally important to know how not to lose money. No trades are 100% winning trades. There will always be bad days that will shock your portfolio. The key to be able to survive these shocks is really risk management. This is where the true survivors differentiate themselves from the quitters.
2% Rule Illustrated
The 2 percent rule is a common guide that is advocated by many traders to manage your risk. Let’s say you’ve worked a couple of years and saved enough money for trading and you’ll like to put in $30,000 for trading. If you are relatively new, there can be a high chance that you’ll not be very successful in your early trades. Just a reminder, 90% of traders lose and only 10% are winners.
Take a look at how your portfolio can be affected if you start off with some losing trades. Say you put a 8% cap on all your loses and winnings.
Figure 1: Risk Scenario
If you start off with 5 losing trades, you will end up with a whopping 33% drop in your total portfolio which is a loss of more than $10,000. For a new trader to get into such loses, there is a high likelihood that you will call it quits and decide that trading is not for you. It is not just the money but the psychological impact as well. You may end up walking away with a $10,000 loss that will live with you for life. This is not some story that is being made up because I have friend who turned away from trading stocks and started exploring forex but went through a second round of disappointment. He ended losing more than half his savings after 5 years of hard work. I personally went through a similar path except that I perservered and kept learning how to become a better trader.
Luck comes back around or you started becoming better and make more successful trades. You make a come back with another 5 winning trades capped at again similar 8%. You’ll notice that you will be down by $948 which equates to 3% drop in your original portfolio.
Say you are a relatively good trader with a 50% winning record but just bad luck that you start with a first losing trade. With similar risk management, after 10 trades, you’ll still be losing $948.
You may be thinking, “If I will be losing, then I won’t even be trading.” Reality is that in every trade you make, you are already in a losing position. Factor in your trading commission and transaction fees and you are already down the second you place your trade.
Adjust your win & loss cap to 2% of your portfolio and compare the results.
After 5 consecutive losses, your portfolio is down by about 10% which equates to about $2,900. You will definitely still be able to stay in the game. Luck comes back around and you start making profitable trades and after a total of 10 trades, you are down by on 0.2% and a loss of $60. Likewise if you are on a 50% winning record, starting with a first losing trade, you will also be able to maintain your capital.
I can’t stress enough the point about limiting your risks. Capital preservation is the ultimate key to survival and what differentiates a survivor from a quitter.
I am planning of writing about position sizing. If you are keen about this subject, write in via the comments below and I’ll give it utmost priority.
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