Trading Risk Management

Many times, the difference between a good trader and a great one is risk management. Knowing when to trade bigger, when to play conservatively, and when to call it a day are all skills traders develop over time.

You aren’t going to have a winning trade every time, so it’s important to make the most of your winners, while limiting the losers. Even if you are wrong more often than you are right, risk management can keep you profitable. Consider a trader who averages $50 on every winning trade, and keeps his losses to an average of $20. This trader only has to be right 30% of the time to be profitable (out of 10 trades, lose 7 for $140, win 3 for $150). The same trader who lets his losses run to an average of $50 has to be right over 50% of the time to be profitable.  Your plan entering a trade has to account for this.

wolvesManaging losing trades should be easy – exit the position. Whatever the trade is, if it is below your risk management parameters, you were wrong, and you need to be out of that trade. Trying to manage a losing trade not only costs you money, there is an opportunity cost as well.  While you are trying to manage your losses in one trade, you are missing out on other profitable trades, possibly in the same stock! Say a stock heads down off the open, and you think it will reverse and head higher.  You buy it, and it goes below your risk parameters. Your instinct might be to hang in there – “I was just too early”, “I need to give this trade room to work”, “If I buy more here, I only need a little bounce to get back to even”, etc.  Ultimately you hit out of the trade for a big loss. Looking back at the stock, it looks like an obvious short, but you didn’t have the opportunity to short it because you were working out of your initial trade. If you had just hit out of the first trade at your risk management parameter, you could have looked at the stock from a fresh perspective and possibly shorted it instead.

Conversely, managing winners takes work. That seems counter-intuitive – taking profits is easy, after all. But unless you have a strategy that has a very defined exit for winning trades, you should constantly be monitoring winners for ways to extend their profitability. The old adage is “cut your losses, and let your winners run.” A stock may get to your initial target, but still appear strong. Discipline suggests you take some profit, but keep some in the trade for further gains. Let the market tell you where to get out. A good quote on this comes from Jesse Livermore in the book “Reminiscences of a Stock Operator” by Edwin Lefevre: “They say you can never go poor taking profits. No, you don’t. But neither do you grow rich taking a four-point profit in a bull market. Where I should have made twenty thousand I made two thousand. That was what my conservatism did for me.” That book was written in the 20’s, but remains essential reading for any trader today.

It is also important to journal your trading, especially as you are starting out. Look at what your risk parameters were when you entered the trade, and keep a record of whether you stuck to them. Just as important, take a look at your winners, particularly for how often you reach your initial targets. If that percentage is low, you may have unrealistic expectations, which causes you to loosen your loss limits. For instance, if you go into a trade thinking the stock will rally at $1, a $0.25 loss limit seems reasonable. If the realistic target is only $0.50, however, that loss limit is too wide.

Overall, have a plan and be disciplined. Don’t be afraid to cut your losses – there will be other trades, don’t push to make this one work. And once you have one that’s working, work hard to make the most of it.

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