Most people give very little attention to money & risk management aspects when it comes to stock trading. And to those who do, it is only treated as an after-thought.
In most cases, huge emphasis is given to analysis and techniques of assessing trading opportunities.
The following is a summary of 6 steps money & risk management strategies that have served me well over the years. They had saved me from being poor while at the same time gave me space to fine-tune and modify my trading approaches and got back what I’ve lost in the market. Now I’m not saying they are the only ones available in the market. It’s just that they are the ones that have been useful and profitable to me. And just what are the 6 STEPS? Well, read on!
STEP 1 – TRADING BULLETS
No money, no trade! No argument there! You need to set aside some money just for trading purposes. Just like what you would do when you set aside your money for children’s education, emergency fund, etc. You should not, must not, borrow money from anybody (banks included!) just because you have that burning ambition to bring in huge rewards from trading.
Don’t have enough money? Start saving. If you cannot even do this, then you’re not ready for trading. Period.
Never do a Hail Mary and dump everything that you have in one single trade, no matter how much you love THAT stock! Don’t be a Rambo in the stock market! Those who do not bother about money management are the ones who would dump all their money in one single trade. Don’t put all your eggs in one basket.
STEP 2 – RISKY BUSINESS
Trading success depends on how you manage risk. It’s NOT based on how you choose your stock.
Every Tom, Dick & Harry talks about risk control. But most of them still lose money! Good trading means you lose only a small amount of money.
First and foremost, you need to know your risk tolerance. In other words, you must identify where your stress point is. How much money can you afford to lose without losing your sleep? How much money are you willing to lose in a single trade? These are some of the questions that you need to ask yourself in order to determine your risk threshold.
Risk can be controlled and minimized to a level that is comfortable to you.
STEP 3 – WHEN TO BUY
When do you jump into a trade? The simple answer is that it depends on the trading plan that you follow. There is no right or wrong answer. Whether or not you make money out of it will only be known after you have sold your shares. It is not uncommon that a sell signal to me may be a buy signal for you and we both still earn profits from our own trading systems. Anytime is a good time to buy as long as the conditions are in accordance with your trading system.
There are as many trading systems or plans as there are the traders themselves. Within the technical analysis fraternity alone, there are the trend followers, breakout traders, momentum chasing players, day traders etc. Some traders would buy on price weaknesses, uptrend breakouts and rebounds. The trend followers would join in when they feel it is safe to hop on-board the moving trend train.
Many traders spend considerable amount of time in deciding when to enter a trade. My view is that setting exit conditions is MORE IMPORTANT than entry conditions! Why? It’s the exit price that determines your overall risk and profit! It is for this reason that I spend more time defining the exit conditions for each of the trade that I intend to take rather than the entry conditions.
STEP 4 – STOP LOSS (EXIT CONDITION)
In property, the most important thing to remember is location, location, and location. In the stock market, its stop loss, stop loss & stop loss! Identify stop loss conditions before you enter trade. This is your insurance if you’re wrong about the trade.
The ultimate role of stop loss is to protect capital and later, to protect profit as the trade progresses.
Not cutting losses is actually one of the biggest mistakes that traders make. Coming a close second is the mistake of not letting your profits run.
Stocks do their own thing, not what we think they should do.
Suppress the urge to be “right” – focus on the need to be disciplined when executing your trading plan. Lose your opinion – not your money!
Most importantly, choose a stop that you would definitely act on!
STEP 5 – POSITION SIZE
It’s inevitable that you’re going to lose money from time to time in this business. Everybody does! But what separates the pros from the boys is that the pros minimize their losses and maximize their profits. The retail crowd would do exactly the opposite – let the losses run and cut their profits short!
If you’re still new in the stock market and lack trading experience, it is absolutely important for you to know how to control and minimize risk effectively whilst you go over the learning curve.
And just how do you minimize the risk? One way is by simply reducing your position size, which is the number of shares that you intend to buy. Don’t bite more than you can chew. Fact is, the traders who win are those who minimize risk. And those who don’t? They pay the price and get wiped out.
In fact, it’s a good idea to trade in small position sizes when you’re new in trading. I also keep my position size small whenever I want to test out a new trading approach. If it bombs out, that’s OK as I’ve already planned for it. I consider that as “service charge” by Mr. Market for giving me such “advisory” service!
Ultimately, your intended or actual position size would depend on the level of risk that you’re prepared to take.
STEP 6 – RISK REWARD RATIO
The purpose of using risk reward ratio is to assess whether the intended trade is worth taking the risk. This analysis tool is useful when you have already identified a sell price target for a particular stock that you want to trade.
Let’s use an example to calculate the risk reward ratio. Suppose you have set your entry price at $7.00. Your stop loss is set at $6.34. And you have made up your mind that you want to sell this stock once it hits $10.00 (your sell price target). The calculation of the risk reward ratio would be as follows:
Risk Reward Ratio = (Sell Price – Entry Price)/(Entry Price – Stop Loss)
= (10 – 7)/(7 –6.34) = 4.55
Stocks that have ratios greater than 2 are potential trading candidates. Better trading candidates are those that have ratios greater than 3.
Risk reward ratio can also be used as screening criteria for trading candidates.
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