................ 10 Rules To Risk Management ...................
For those of you who follow sports, professional athletes always go through a spring training, a summer camp or some other period of adjustment prior to opening their season. During these training camps, regardless of experience, they will usually go over "the basics" of their trade.
One of the "basics to trading" is risk management. I thought I would take the time to list some of the rules I use with regard to risk.
1. When starting out, use small share size, at least for many months.
When trying out new strategies to see how they work, one doesn't need the added pressure of taking large drawdowns. Taking on more size than is necessary causes one to make bad investment decisions. We sell when we should buy, we buy when we should sell. Start small and increase the size of your positions as your system shows success.
When your trade doesn't work, critique yourself. Was your losing trade the result of poor analysis or was it the result of poor execution? The answer to that question will determine how you make your next trade.
Keep in mind, most of the time, large wins usually means large exposure. If you are too exposed, you will be in position to give back all that you earned, if not on the current trade, on the next or the the one after that.
2. When in doubt, get out.
You should have an idea of how the trade should develop prior to your entry. If the trade isn't working the way you envisioned, then close your position and wait for another opportunity.
Hope may be the magic ingredient in motivating yourself and others but hope doesn't motivate share prices. It's better to miss an opportunity than it is to take a loss. When in doubt, get out.
3. Learn the difference between gambling and trading.
Don't short a stock just because it's irrationally high. Often times when a stock is irrationally high, it's because institutions are driving prices higher. You don't have the financial strength to fight institutional money. Learn to look for weakness first.
Don't go long a stock just because it is irrationally low. Like the above, you may be fighting institutional money. Learn how to read the volume charts to determine supply vs demand.
Don't take positions prior to major announcements. You don't want to put yourself in a position where it is all or nothing. You just might end up with nothing. Taking positions ahead of major announcements is gambling. You can lose months of profits on one trade.
Keep in mind, that volatile stocks have blown out more accounts than anything else. You don't need an entire move to be successful. Learn to capture most of the move. Leave the bottoms and tops to the novice traders.
4. Don't add to losers.
For those of you who didn't grasp that, let me repeat it.
DON'T ADD TO LOSERS!
Everyone of you can provide a case where averaging down bailed you out of a bad trade. Although you can site an example or two, it isn't a recipe for long term success. The fact is, if you cut your loss sooner and patiently waited for the stock to turn around, your gains would have been even greater and you would have done it with less risk.
Not every trade you average down on will work out. The odds are against you. Learn not to depend on luck to bail you out of a stupid trade. Learn how to play the odds.
5. Don't overtrade.
A big mistake by traders is to try and get revenge for a bad trade. They think the stock or the market owes them something. So, they increase the size of the trade to try and make up for the last one. Often times, when they are down, they will try to increase the number of trades they make. Don't increase activity unless you are on a winning streak. To increase activity and lose only compounds your losses.
When you are in a losing streak, lower the number of trades you make and decrease the size until the market turns around and agrees with your style of trading.
6. Don't increase share size to make up for losing trades.
This step has already been mentioned in step 5 but, is worth mentioning again.
7. Have a loss limit.
Know in advance what is the maximum loss it will take to prove you wrong. Too often, people will say they are down too much to sell and they will say they are now a long term investor due to the loss. Know where the point is that allows you to cut a loss as opposed to being a long term holder.
In my case, I have learned that a 3% loss is the maximum I am willing to take and still not lose confidence in my strategy. Others may find it is 8% or 12% or even more. The important thing is, you must know where the trade shows you are wrong, and you must know where the inflection point is between cutting your losses or switching from trading to gambling, and now you have to rely on hope and averaging down to bail you out.
8. Be logical, not emotional.
This is easier to say and harder to practice. People often times get their self worth from their success in trading. One must learn to separate their ego from their trading if they are going to consistently outperform the market.
By putting your faith in your strategy, it is the fault of the system, and not you, when the trade fails. All you can do is identify the set ups. You don't have any control over the results. If you look at the trades logically, when the set ups don't have the follow through you envisioned, it's not your fault. It's your fault if you allow your ego to get into the way and hold the position when it turns against you.
9. Don't trade if you are having computer problems or getting slow quotes, or your attitude isn't positive.
If you are having computer problems, blood pressure can rise when you can't get up to date information. This will cause you to make poor decisions. If your tools aren't acting properly, shut them down and go cut the grass. The market will be there when you get back. It's better to miss an opportunity than it is to make a poor trade due to inaccurate information.
If you are tired, depressed or angry, don't trade. Go work out or do something else until your mind is right. It's hard enough to make a profit in the best of mental times, we don't need the added pressure when our mind isn't right.
10. Be disciplined.
Discipline is the tie that binds! Have a set of rules. Have a trading plan. Flying by the seat of your pants won't provide consistent profits. You are trading against people who do this for a living. They will eat your lunch if you let them. Don't change rules in midstream. If the trade isn't going your way, get rid of it. Have the discipline to follow the rules established above. The choice is yours. That's all you really have control over, the discipline to manage risk.
Whatever you do, don't lose money!
If you have to lose money, lose small.
If you lose small, you won't need huge returns to get back to even.
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