Effective Risk Management
At Wanderer Financial we harp on the absolute necessity of a trader to strategically manage their risk when trading. There's a reason we do that—risk management is the number one thing that separates who will earn a living from trading and whose account will dwindle their way straight out of the business in a year. You can't be a successful trader if you are constantly needing to dig yourself out of a deep hole. In golf, it's easy to chip your way out of a divot, but you wouldn't be able to chip your way out of a six-foot hole in the ground.
So let's take a look at a couple of simple things that we should do on every trade to limit our risk.
One: KNOW YOUR STOP
Don't just know about where you would get out, know to the penny where your stop is—the exact point where you would say, “This trade is wrong.” We don't go into any trade knowing that we are right. We make educated decisions that we feel give our trade a better than even chance of going the right way, but in the event that it doesn't we must have a plan in place ahead of time.
We can't calculate our reward-to-risk level without knowing where our exits will be—both to the upside and the downside—and we can't take a trade in the first place without knowing we've got good reward-to-risk. Much of trading revolves around where a loss will be taken—every bit as much as where a profit will be taken. In order to have effective risk management we need to know both.
Two: PLACE YOUR STOP
You don't want to leave yourself open to second guessing. Psychologically, accepting a loss is difficult. But what's more difficult is letting a small loss turn into a big loss. Recovering from large losses requires many large winners. Nobody wants to have a string of big winners that does nothing but get them back to even. With stop orders in place, the decision at the critical moment is out of your hands.
All traders will have many losses. The key to losses is to be able to easily offset them with the winners—something which becomes more and more difficult the further you let your losses run. In trading there's a saying, cut your losses early and let your winners run. Do that, and you've won the biggest battle.
Placing a stop immediately after purchasing the stock is the easiest thing you can do to manage portfolio risk.
Three: MOVE YOUR STOP UP
One of the most important things we do to maintain consistent profits is to move our stop up. There is nothing more frustrating to new traders than watching a nice winner turn into a loser, even if it's a small loser. To avoid this we move our stops up quickly. Once you've got a decent profit in a trade, generally around 2-3%, move the stop up to break-even. It's comforting to know that you aren't going to lose money on a trade.
As the stock continues to climb you move the stop up with it. There's no hard and fast rule on where to move it to, but look at the chart and you'll find the obvious levels of support (as you can see in the previous examples), and you can move the stop just below those. By doing this you'll guarantee a profitable trade remains profitable by taking away that "it's going to turn back around" urge that you'll be fighting when the stock begins to fall.
We want to see everybody enter trading with the best chance of success, and the only way to do that is to manage risk effectively. By using stops religiously, you will limit losses, you will quickly secure a guaranteed profit, and you will consistently increase that profit. Stops are your friend. Use them.
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