Essential Risk Management for Trading
Percentages of Risk
As a new trader, you need to determine what percentage of risk you are comfortable with per trade. This is how much money are you willing to possibly lose if the trade does not do what you want. This is why it is called risk. Risk is the possibility of loss or peril.
Most experts will tell a new trader that they should not risk more than 1% of their total portfolio in any one trade. A new trader with $1,000 would only be trading $100 per trade. I would push the envelope on this percentage and would state that new beginners should range between 1% and 5%. But hit the extremes rarely, and focus on around 2-3% with a stop loss.
Marking Your Risk Statement
We will say that you are trading with $5,000 and willing to risk 2% per trade. So the image above shows DGAZ is at $15.46 currently. If you were willing to risk $2.00 per share then you would be able to take a position of 50 shares. This would be determined by: 5,000 * 0.02 = 100. So this would be $100.00 per trade of risk. Divide our acceptable risk of $100.00 by how much per share we are willing to lose. This was stated to be $2.00. This equation would be 100 / 2 = 50. This would be the total amount of shares we are willing to purchase with our stated risk values.
Knowing these numbers allows us to purchase 50 shares and set a "stop-loss" order to close our position at $14.10. This means that if the price hits $14.10 or lower we will automatically sell our shares of DGAZ and limit our loss instead of letting it to continue to lose our money.
Know When to Fold
Instead of simply guessing a price that you are willing to lose per share, it is better to look for a support level. If you look at DGAZ above, you will see where I have put an arrow pointing to a line. In the past, DGAZ has hit prices around $14.12 and bounced up from there. This would be the support level, and a good point to sell at. If the price falls through the floor, or breaks the support level, it can fall and lose money fast. This is limiting your risk of loss.
By setting the stop-loss to the support level and taking this as the risk, we can rework the example above for DGAZ. When this image was taken the support was approximately $14.12. I would round down to $14.10 and that would change our acceptable loss per share from a random $2.00 as in the previous example to: Current Price - Support Level = Risk Per Share. Which in this case would be: 15.46 - 14.10 = 1.36. And 100 / 1.36 = 73.53. Since we can't purchase 0.53 stocks this would be 73 stocks.
This gives us better risk management because of the set support level as well as more stocks to leverage possible earnings. We are attempting to keep our loss risk at $100.00. There could be a gap, and it needs to be stated that this does not guarantee we will only lose $100 if the price goes down. But it helps limit our risk.
Why Plan Losses
Everything in the market is about limiting how much you give back. Most new traders will either not pay attention to loss potential or get caught up in the excitement and forget about it while focusing on how much they could gain. Then when they start losing, they will their holdings will turn around and that they should hold them until they do.
Sadly, this may not happen, or it will continue to keep capital tied up and doing nothing. And capital should be working as often as possible. If you plan on losing 2% percent, it is easy enough to make this back in a trade or two. Plan your risk and cut when you hit that limit so you can come back again. Always analyze what went wrong with your trade if you lost, and if you win - look at how you could have done it better.
Good luck with trading, I hope you plan your trades and are successful.
Questions & Answers
© 2018 Chris Andrews