The Stock Market is a jungle. Tons of Fear and Greed gets generated every second, every tick and every trade. This is what makes trading so hard and frustrating but there is a way around this and it’s called Risk Management.
What are the Risks?
We deal with many risks each day
- Physical Risks such as driving a vehicle, taking a train or simply walking somewhere
- Emotional Risk such as trusting and loving people
- Career Risk such as taking a job, leaving a job or staying in a dead end job for years
These are all risks we take daily and most of the time without hesitation and I personally think it’s because we perceive them as being part of ordinary life.
Risk is ever-present but in various degrees
Trading is considered by many as a risky business but what ordinary business is not a risk. Trading seems risky to traders when they are fearful and anxious. So it’s important to remove fear from our trading to put ourselves in the best frame of mind to make wise trading decisions.
Define your Trading Risk
Defining the risk amount per trade will greatly reduce the Fear we experience from trading. It should be a value that is comfortable for you to lose per trade and yes there will be trades that do not work. Each person will have a different Risk value but the 2% rule is a good starting point for any trader.
The 2% Rule explained
Let’s say I have 100000 (dollars, euro’s etc) trading capital
- I want to buy X that is trading at 100
- I have determined to place my stop loss at 95 (I prefer a standard 2% percentage personally but you can use technical analysis or even your horoscope J). So my loss on a single stock will be 5.
So how much stock do I buy?
First work out the risk amount which is 2% of your entire trading capital as per the rule.
Risk Amount = 100000 × (2/100)
= 100000 × 0.02 = 2000
This risk amount is the figure you would lose on this trade if it fails.
Stocks or Shares to buy = Risk amount ÷ Loss on a single stock
= 2000 ÷ 5 = 400
So I will only buy 4oo shares @ 100 (Total capital used = 40000) with a stop at 95. This will also help in diversifying your portfolio as you will not invest all your capital in a single trade.
The 2% rule will also force you to trade smaller when your account gets smaller and larger as your trading results improve because your calculations are all based on your current trading capital.
Risk of Not using a stop loss
Turning a short term trade into a really long term investment... Anyone that’s ever traded has been guilty of this felony at least once, me included J. What happens is that I’ll Buy X at 10 pts expecting it to go up but it doesn’t, it falls and I’ll wait ...then hope...then pray. The danger of falling into this trap is that you could lose all your investment or even more if you’re trading geared instruments.
Humans in general hate being wrong and in my example I was clearly wrong but would not face the truth. I realised very quickly that I could not trade without acknowledging the truth and acting responsibly, this is something vitally important for traders and setting a stop loss is the start point.
Advantages of setting a stop loss
- You limit losses. Taking a small loss on a trade is acceptable if the market moves against you but taking a big loss can hurt both financially and emotionally.
- You take responsibility. Trading is unlike other professions where manipulating people and circumstances is possible. Taking responsibility by setting a stop loss gives you control over your destiny and instils discipline in your trading.
Important Tip: Always save your broker’s contact number on your phone
- Trading a liquid market (very active buying and selling) is way better then a market where only a handful of trades are executed every hour. This is important as the spread (difference between the best bid and offer) tends to be bigger on slow illiquid markets, simply meaning your order may not be filled if your stop gets triggered.
- Markets have noise and your stop will be triggered sometimes before moving in your direction. That happens and it sucks but it’s still no excuse to neglect using a stop. We tend to feel like losers when a trade has not worked out but you only really a loser if you ignore your stop and let a loss get out of hand. The first loss is the best loss.
- Protect your capital first through money management techniques such as the 2% rule. In cycling there is a rule ‘no helmet no ride’ in trading it goes ‘no capital no trade’ and that’s simply no fun.
- Discipline yourself to apply your risk strategy every time, it will give you an unbiased view of whether your trading is improving or not.
Using a stop loss will benefit any trader regardless of what you trading. There are no certainties in trading, no matter how great the preparation has been for a specific trade and setting a stop loss is your safety net.
Please don’t just trade aimlessly, take action and formulate a plan. I wasted time, money and opportunity when I started trading because I just jumped in. Make simply rules for yourself and stick to them. Only then can you determine if your trading is profitable or not.