I was talking to someone about my blog who is not very familiar with trading and they mentioned being a little lost on how I was figuring out how many shares to buy, how I ensured that I didn’t lose all the money that it took to get into the trade. From a layman or very new trader’s perspective this makes so much sense. So, I wanted to write a little about risk management. This is effectively the most important way to ensure that you DO NOT blow up your trading account and lose all of your money. This is also one of the reasons that most traders fail at trading, they do not manage risk properly. First off when it comes to risk management you have to be able to take small losses to protect your account in order to live to trade another day. Below is one of my favorite quotes about trading.
“If you cannot take a small loss, sooner or later you will take the mother of all losses.” -Ed Seykota
Here is how I manage risk in my trading account. I have about $50,000 in my trading account. I know that is a lot more than most people start with but it does not mean that it is a requirement this is just an example and I feel like using real numbers makes it easier to understand. You want to try and only risk 1-2% of your account on each trade, for my account that would be $500-$1000. This way you would have to be wrong 50-100 times in a row in order to blow up your account. Now, since I am still a newer trader I am starting using a R (risk unit) of $300 per trade. But wait Robert, look at the trades you have posted for instance the WDC trade you said you short sold 429 shares of WDC at $85.80 per share that is $36,808.20 worth of stock at risk. Well yes it would take that mush cash or margin in order to enter into the trade. But this is how you mitigate that risk so that you don’t blow up your account. You use predefined triggers, stops, and limits to enter and exit ALL trades.
Going back to the WDC trade. My entry into the trade (a short) was $85.80 and I wanted my stop at $86.50 based on the chart. So this is how I determined how many shares to buy $86.50 – $85.80 = $.70 cents worth of risk per share. If my risk is $300 per trade then I take $300/.70=429 shares (I rounded up to a full share). This way if I short WDC at 85.80 and it goes up rather than down like I wanted it to once the price of the stock hits my stop (86.50) my broker triggers my trade automatically to buy to cover those shares, thus making sure that I only lose $300. Now there can be some slippage and I could possibly lose a little more or less depending on the fill from my broker which is why you only want to trade stocks with good volume so that there is good liquidity and you can get in and out quickly. That is how I am only risking my R unit per trade no matter how much it costs to enter each trade.
More examples could me a .10 risk per share, $300/.10 = 3000 shares, .25 risk per share, $300/.25 = 1200 shares, $1 risk per share $300/1 = 300 shares.
Now enough about losing money, what about making sure there is enough reward out there to capture? Would I risk $300 if I though I could only make $150 based on the move of the stock in the direction I wanted it to? Heck no! I generally look for trades that have a risk/reward ratio of at least 1:2 if not more. So, based on charting if there is a good stop and entry with $1 worth of risk, I want to make sure the chart shows that there is a good chance or edge as we like to say to capture a $2 or $3 move. For instance, with the WDC trade for my $.70 worth of risk I wanted at least $1.4 of reward. I.E. shorting WDC at $85.80 and buying to cover at $84.40. In a nutshell that is how I set up my trades and ensure that I manage my risk. I NEVER move my stops to put more risk on the table and I never enter trades without a predefined risk management stop in place. I hope that helps you all and if you have more questions about any of this feel free to shoot me an email and I will help walk you through it a little more.