Trader Mom @ Home

The primary goal to invest/trade in the stock markets is to make money.  However, we will never achieve this goal if we do not know why and how to manage risk.

Why risk management has top priority

In trading, risk management is far more important than anything else.  To make money, we need a trading stake.  How could we make  money if our trading accounts are wiped out or our capital is tied in some rotting positions?  It is absolutely  OK to have losers. But it is NOT OK to hold onto them once Mr. Market has warned us to get out.  Here is a post about how to treat losers and another about how to set stop loss orders.  

How to control your risk

So the first thing is to cut the losers.  Nevertheless. It is not enough to just cut the losers. If we have many losers to cut in a very short period of time, they can add up quickly.  We will have to set our overall loss cap and adjust our position size accordingly.  For day trading, our loss per trade should not exceed 0.5% of our total capital and our daily loss cap should be no more than 1.5% of our trading capital.  In other words, we stop trading after 3 losers in a row. A daily loss cap is not enough; we need to set a weekly cap too. My weekly cap is 5%.  If I have lost 5% by Wednesday, I will stop trading for the rest of the week.  And my monthly cap is 10%.

We will also have to pay attention to our position size. Position size should be reduced to a level where we can feel comfortable without looking at it or thinking about it constantly. If we are constantly worried about our positions, then they are too big and our judgment will be impaired.

In order to control position size, we will have to pay attention to what sectors our positions are in. If we have MOS and POT at the same time, then they are considered one position since they move together most of the time. We should only have one of them or at least split our capital between them.  For example, after careful studies, you feel comfortable with 10k per trade.  You normally choose whatever is the strongest in a sector. Let’s say MOS. You put 10k into MOS and have nothing in POT. If you really like POT, then do a 50/50 or 60/40 split between MOS and POT.  You just can not have 10k in each since that would be equivalent to 20k on a fertilizer stock.

Another advantage about reducing the size of our positions is that we can use a wider stop loss and still stay within our risk threshold. If our risk for each trade is 200, then our stop loss would be 2% of a 10K position or 4% of a 5k position.  With the same amount of risk, a wider stop loss works better than a narrow one.  Of course, our profits will drop due to the reduced size.  But once again, I will put risk control before anything else in trading.

Here is the recap

1. Cut losers
2. Set a daily/weekly/monthly loss cap
3. Control position size
4. Pay attention to sectors