“I had no idea the stock would fall like this.”
His e-mail read like a frantic trader that risked too much, the wrong way.
“I just lost $15,750 on that trade. There was nothing I could do. Any suggestions?”
What could I tell him? Sorry? Better luck next time?
Instead, I explained to him what I tell all students.
First, remove the emotion from your trading, including the excessive fear and greed.
That doesn’t mean you have to have ice flowing through your veins. It simply means you need to re-think your strategy.
No matter what your emotion says, never allow emotion to dictate your trading action.
Second, never wait to take profits…
If you have good profits in hand, take them. Exit half of the position and let the other half run. But don’t leave profits on the table for too long…
Third, never risk money you cannot afford to lose. Don’t be that person, the fool that thinks Wall Street is a get rich quick slot machine that does nothing but spit of winnings.
It’s a great way to lose money.
But if it’s not emotion, it’s the lack of money management.
You must manage your money well, or you can lose it all.
Trading without a plan is as good as an idea as driving blind. Money management defines your risk. How much are you willing to risk per trade?
It also gives you a way to set aside a set dollar figure per trade each and every time. We don’t know if any next trade will be a winner or a loser.
Why bet the farm when you can’t afford to lose the farm?
None of us can afford to do that…
If I knew that 7 of my last 10 trades would be a winner, but I didn’t know which ones, how would I allocate my capital risk? To be safe, we’d allocate up to 5% max on each trade. This way, you control your risk without risking the farm. I apply the same risk to each trade.
Depending on whom you speak to, experts say to risk 1% to 3% of working capital on any one trade. The most I’d say is 5% max. If you have $50,000 in capital, maybe use $2,500. If you have a $5,000, account, maybe risk $500 to start out.
You can always work up.
How much loss can you tolerate? Don’t use a % until you realize the $ amount it translates too.
Once I know the $ equivalent, I can create a play plan. Let’s say a given trade is $200. I have a $5,000 account, and I’m willing to allocate $500 to this trade. I can safely buy two contracts at the moment, which is fine. It is still good exposure. We have to stick to the plan.
Define market factor risk now.
We may one day have a repeat of a 2008-2009 sell off.
It can happen.
To prepare, you need to think about exposing yourself to less risk if the volatility in the market is too high. Lower your capital risk and your stop loss if need be. Markets don’t go up or down in an orderly fashion.
Or, if it’s not money management destroying your portfolio, it’s the lack of a stop loss.
As an investor, you should be familiar with a stop-loss, or the order given to a brokerage to sell a position once it drops by a certain amount or hits a certain level.
With stocks, it’s always safe to use a stop loss of -25%, on average.
With options, it’s a safe bet to use a stop loss of at least -35%.
We can also employ trailing stop losses, as well, which remove the emotion from your trade.
Remember, emotion is a portfolio killer. Remove it, and you stand to do even better.
What’s nice about a trailing stop is that it will adjust higher as the price of an asset rises, thus allowing the investor to lock in gains.
For example, if a long position were bought at $10 with an initial 25% stop-loss set at $7.50, the trailing-stop would rise if the price of the asset continued to rise above $10.
Trailing stop losses are essential in today’s trading environment.
Say you bought stock ABC at $6 a share.
As it pushed toward $9.00 a share just weeks later, you begin to get a bit nervous that the run is coming to a near-term end…
To protect your gains should the bottom begin to fall out, you can use a 10% trailing stop-loss. In this case, you’d set your trailing stop-loss at $8.1.
Or, ($9 x 10% = 90 cents; $9 – 90 cents = $8.10).
This way, should the run end, you still lock in a solid gain of 35%.
If the stock continues to head north, nothing happens.
The trailing stop-loss isn’t triggered. However, if the stock turns south and hits that trailing stop-loss, the stock is sold — and you pocket the profit.
It’s a safe, easy strategy that should be part of all portfolios.
As an investor, you should already be familiar with a stop-loss, or the order given to exit a position should it drop by a certain amount or hits a certain level.
A stop loss order tells a broker to close out a position when it hits a specific price. It takes the emotion out of trading. Once the stop order price has been hit, the position is closed.
If a trader bought a $20 stock and placed a -25% stop loss on the trade, the trade would be automatically exited if – and when – the stock hit $15 a share (25% of $20).
The Most Important Lesson
Look, removing emotion from your trade isn’t an easy task.
We all know this. But if you allow it to dictate how and where you trade, you will lose money more often than not.
Success is not always a guarantee.
But if you have a plan in place, you increase your odds significantly. Trading isn’t about having the perfect strategy. It’s about having the discipline to know what to trade, when to exit, and how much to risk per trade.
Jumping without a net is never a safe idea.
One of the biggest issues facing all walks of traders is a severe lack of discipline and structure in stock buying habits. Many fail to use stop losses, or even protect gains with a simple trailing stop loss strategy. Others risk far too much.
A friend of mine once made 275% in a week’s time on a trade.
Then he risked it all on the very next trade that cost him 90% of that 275% winning.
That’s a recipe for disaster.
A trader with no plan for action has already lost. Do you know when to exit on an up or down move? What stop losses or trailing stop losses do you have in place? Know these things, and set a plan so you won’t run into “crash and burn” scenarios as often as those with no plan.
- Know when to just walk away from a trade. Remember, stocks don’t just move up. They also come down.
- Lower expectations. Inexperienced traders expect to quit their day job and make a fast-paced, hot lifestyle out of trading. That’s not going to happen. No one ever became a brain surgeon or rocket scientist first year in. The same applies to trading. If you make a mistake, learn from it. Don’t repeat it.
- Remove all emotion from your trading. That doesn’t mean you have to have ice flowing through your veins. It simply means you need to re-think your strategy. No matter what your emotion says, never allow emotion to dictate your trading action.
- Have money management techniques in place.
- Have a stop loss and trailing stop loss strategy.
The top rule — Never risk money you cannot afford to lose.
Safely allocate and understand what you may or may not be able to lose.
The market is not a sure thing.