Consistent profitability in stock trading is a matter of managing risks through disciplined execution of a well constructed trade plan. Without a sound plan, traders will get lost in the fog of emotion and eventually lose their money due to impulsive decision making.
Blindly trading stocks lead traders to cling to hope as they wait for a miracle for the price to shoot up. However, hope is never a strategy in stock trading and investment. If you have no measurable means to gauge risk, you will do more damage to your money and will cause you to throw in the towel in frustration.
Focus Within Your Realm of Control
Building your risk management strategy starts by identifying the variables you have control over. Any element in the plan that you can control can be measured and improved to increase your rate of success.
Stock Trading Variables YOU HAVE CONTROL Over:
Stock Selection (The stocks you choose to monitor and trade)
Stock Price Entry (The stock price wherein you buy)
Stock Price Exit (The stock price wherein you sell)
Stock Trading Variables YOU HAVE NO CONTROL Over:
Price action (How the stock moves in the short term)
Company performance
Institutional Buying and Selling (The rate wherein the major financial institutions accumulate and exit)
News (Positive or Negative News at any given time)
Market Sentiment (How the investing public views the stock or the general market)
When you know the things you have control over, you can start crafting a plan to measure, monitor and execute the variables and calibrate the metrics depending on the results you get.
Align Risk Management to Your Investment Horizon
A long term investor and an active swing trader have a very different approach to risk management.
Investors with a long investment horizon has a lot more space for market volatility:
Supports and Resistances and other technical indicators are plotted using larger time frames (monthly or yearly).
Investors who are investing in the long term growth potential of a company Average Down by buying in tranches when the price forms new support levels.
Long term investing rarely monitors market moves on a daily basis.
Active traders with a shorter investment horizon leverage on the daily fluctuations in market volatility:
Supports and Resistances and other technical indicators are plotted using intra-day (1 minute, 3 minutes, 5 minutes) and daily time frames.
Implementation of specific market timing components are made to allow the trader to buy low and sell high for quick profit.
A Cutloss strategy is implemented to the trade plan to exit plays with failed setups. It allows the trader to settle for a small loss to be able to protect the portfolio from even bigger losses.
Active trading demands daily monitoring to be able to screen the best plays.
How to Measure Risk?
Risk is measured by using technical metrics to gauge the amount of money you may lose if the stock moves against you. In this context, the use of Technical Analysis is an effective tool to objectively analyze and measure risk.
A simple methodology to measure potential Risk:Reward can be done through the plotting of Key Support and Resistance levels.
In the chart above, the Risk:Reward ratio show a potential -22.50% decline if the current key support at 2.45 fails. The target potential profit if the stock price breaks out from resistance is 16.75%. A clear risk management view on these odds dictate that the current price no longer supports a favorable low risk entry. To put you in a convenient position to sell on strength, the trader should have bought near the bounce point at 3.45 to be able to have a reasonable upside margin to sell at profit. At its current price level, this stock does not seem to be a good short term pick. If you are after a short term play, its time to move on and select another stock.
How to Properly Set a Cutloss Point
A Cutloss Point is a percentage below your average price in a stock position. It is the defensive element of the trade plan that settles for a small loss to protect the capital from a possibly BIGGER loss. This allows a trader to be always open to potential plays in order to remain profitable in the long run.
A simple cutloss ratio is to sell -2% to -3% below your average price assuming that a major support has been validated as broken.
Referring to the chart above, let’s say you bought a stock at its key support of 0.88 for the amount of 50,000php. Historically the chart has shown resiliency at that level. But due to negative market sentiment and bearish market conditions, the support breaks and starts a panic selling move. What now?
Based on our cutloss template you should have sold your position at 0.86, for a total loss of only 7,000php. As you see, the trend after that breakdown has shifted the stock to a steep sell off. That cutloss would be your only saving grace to prevent you from being stuck at .88 with compounding losses.
How Much Risk is Too Much?
An excerpt from Mark Minervini:
"You should definitely keep your losses to 10 percent or less, because losses work against you geometrically. As you get increasingly further away from the 10 percent mark, losses work more and more against you. A 5 percent decline takes a 5.26 percent gain to get even. With a 10 percent loss, it takes an 11 percent gain to get even. A 40 percent loss needs a 67 percent gain. After a 50 percent loss, the gain must be 100 percent. And if your position fell by 90 percent, you’d need a 900 percent gain to get even! How many stocks that you buy go up 900 percent, 100 percent, or even 67 percent? A 10 percent loss is the maximum allowance."
In a Nutshell
Stock trading has plenty of surprises. Generally, things can get sour pretty quick and if you have no risk management element in place, you’ll end up stuck at a loss for a long period of time. So before placing your hard earned money in the market, know the risks you are taking.
The hard truth about trading is that losses will be inevitable. There are times that your trade analysis will not manifest itself in the market and the price will turn against you. If this does happen, your only way of preventing huge losses is to take a small loss at onset so that you can enter a more favorable trade later on.
SMALL LOSSES, SMALL WINS, BIG WINS these should be the only expected result of your trade plan. Risk management is the only element in your trade plan that will protect you from a BIG LOSS. This is why Risk Management always comes first!
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