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Many beginners think trading is simply a question of buying the right stocks at the right time. But risk management is equally important because it may allow them to survive making bad picks.
This article focuses on two key parts of risk management: stop losses and trade sizing.
Stop losses are one of the most common forms of risk management. They’re standing orders to exit a position if prices cross a certain level. That entails selling a stock, exchange-traded fund (ETF) or option that someone owns when it falls below a given value. It can also entail buying a stock, ETF or option sold short when it rises above a certain price.
Traders may want to plan stop losses and exits before entering a position. This can let them select setups with favorable risk and reward.
For example, a stock may have recently held a weekly low at $50 and have a 52-week high of $70. The investor can set a stop loss below the lower level and seek an exit near the high.
He or she might target a 3-to-1 risk/reward. They could potentially purchase the shares around $54 with a stop loss at $49 and a price target of $69. That could represent $5 of downside risk and $15 of potential profit to the upside.
Traders may initially pick stop losses based on the amount of money they hope to make (and then risk a fraction of that). However that’s subjective because the market doesn’t care what they want as individuals.
Instead, they may have more success using specific (objective) levels for stop losses. That could include:
Knowing a stock’s volatility can also help. (Volatility estimates how much prices can move in a year based on recent historical fluctuations.) More volatile securities may require wider stop losses.
Volatility brings us to trade sizing, another form of risk management. Traders may allocate less capital in positions that are more volatile and risk more cash in securities with less volatility.
This can involve complex formulas or simple rules of thumb. For example, an investor with $100,000 might buy $10,000 in stocks with 40 percent historical volatility and $20,000 in stocks with 20 percent volatility. These are just approximations because history can never be trusted as a guide to the future. However having a consistent method can help traders overcome emotional decision making.
Customers may also consider that broader indexes typically have less risk than individual stocks. That can justify larger positions in major ETFs than one might have in individual stocks.
Once stop losses and trade sizing are understood, one important question remains: How much capital should be risked on any given trade?
The 1 percent rule is a common approach. A customer with $100,000 in his or her account may be willing to risk $1,000 per trade. (They would look for setups where the stop loss would represent a $1,000 loss.)
Many variables could influence the percent someone is willing to lose. People with more risk appetite or time could tolerate bigger drawdowns. Active day traders, looking to generate consistent daily profits, would probably want smaller losses. Individuals have different objectives and financial needs. Trading — and longer-term investing — must always conform to those realities.
In conclusion, traders often focus on the money they might make buying and selling stocks. But well-considered pre-determined rules can help minimize the losses that inevitably result from picking the wrong stocks at the wrong time. These risk-management concepts can help traders survive losses and give them the confidence to keep trying after being wrong.
Margin trading involves risks, and it is important that you fully understand those risks before trading on margin. The Margin Disclosure Statement outlines many of those risks, including that you can lose more funds than you deposit in your margin account; your brokerage firm can force the sale of securities in your account; your brokerage firm can sell your securities without contacting you; and you are not entitled to an extension of time on a margin call. Review the Margin Disclosure Statement at www.TradeStation.com/DisclosureMargin.
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