Without question the most important skill you will ever learn when it comes to handling stock is risk management. Most people think they lose money in the market, because more trades go against them than go in their favor. They think a great trader wins a large majority of their trades. In most cases this isn’t true. While there are definitely traders that have a winning trade percentage and some are even up in the 70%+ area, the thing that makes them winning traders is their understanding of risk vs reward.
The truth is many successful traders don’t even win half of their trades. Some don’t even win one out of three, BUT when they lose the losses are tiny in comparison to their gains.
For example if I make 10 trades and I lose 7 out of those 10 it might seem like I’m doing a terrible job, but if we look closer at the gains and losses they can tell a far different story. Let’s say out of those 7 losses my average loss was $200. My average gain for the 3 wins was $900. So in the end I lost $1400 and gained $2700. That sounds pretty good to me.
Now let’s look at the opposite scenario. I win 7 and lose 3. My average gain for each of the 7 wins is still $900, but I have no loss management so each loss will probably be massive. We’ll say they are $2500 a piece on average.
Why would something like this happen? Generally the issue is that people feel that they have to be right. A perfect example is when an investor buys a stock at $55.00 and the stock drops to $54.xx then it goes up to $55.xx. Now the trader with no risk management will say “See I knew this trade was going to make me money.” Sadly the trade starts to take a dive. It hits $54. Then it drops to $53. Now the trader is thinking “Ok so this trade was definitely going to make me money. It’s losing now and I’m getting scared so I’ll just wait for the price to go over $55.00 again and sell immedateily.” HUGE MISTAKE!
If a trade is a loser, it’s a loser. You don’t have to be right. This is generally where something called a stop loss comes in. A good trader will define the rules of their trade BEFORE they ever get into it. For example let’s say John Investor sees that company XYZ stock is at $55 and after using technical analysis he realizes that there is a good margin for stock price growth, and he sees that at $53.50 there might be a good chance for the stock to dip down due to investor fears. $53.50 is known as a resistance point and I’ll get into that more in the next article, but essentially what John Investor is looking to do is create a line in the sand. He’ll say to himself “I’m going to buy in at $55, but if the stock drops to $53.49 then I”m selling and not a second after.”
This takes all of the emotion out of trading. That mindset of “I’ll just wait until the price goes back to where I bought it” is a losing mindset. That’s an emotional mindset.
You want the emotional satisfaction of being right. Well being right is damn expensive and that’s a price no good stock trader is willing to pay. There is a great chance the stock will never go back to the price you bought it at, and even if it does it may take months or even years. That’s a period of time where you could have been reinvesting that money into winning picks.
Ok so I think you get the general point of risk management. Now let’s talk about different types of risk management. There are a ton of strategies when it comes to risk management in your trades, but I’ll just go over the major ones and that should give you a very powerful toolset for dealing with trades that go south.
The different options are as follows: stop loss, trailing stops, scaling in and out, and hedging. This will be a very high level look so keep in mind that there are lots of extra strategies in and around these options, but the first step is to understand what they are and how they work.
Stop Loss- This is the simplest and probably most common trading tool for managing losses. A stop loss is pretty straight forward. When you buy or sell a stock you also set a price where you would like to close your position if the trade goes the wrong way.
Example time! John Investor likes a company with a stock ticker symbol XZX. He think that the current price of $34 is a great entry point, but he is worried about possible losses. Looking at all of the information he has been given he is pretty sure if the stock goes below $32 then it will really start to tank so he sets a stop loss at $31.95. This means that the moment someone sells a share for $31.95 his stop loss will kick in and all of his shares will be sold. He doesn’t have to monitor the trade himself and let the broker know he wants to sell.
This can be a VERY powerful tool for people who get emotional in the moment and want to remove their momentary feelings from the equation or for people who don’t have the time to constantly monitor their stock portfolio.
Trailing Stops- These are very similar to a stop loss except they move up (or down depending on if you’re long or short on the stock) when the price moves up. This trailing can be done with a hard number such as $1 or by a percentage.
So if John Investor buys a stock at $20 and his trailing stop is set to $0.50 then the current stop loss is $19.50, but if the price goes up to $22 then the stop loss would trail that price by $0.50 and go up to $21.50. This is a great way to lock in profits or as many traders say “take some money off the table.”
Scaling In and Out- This method of risk management can be a little bit abstract. Essentially the idea is that you buy in with a small portion of the amount you plan on investing overall. As the trade goes your way you continually buy in more shares (Scaling in). Once the trade reaches a predetermined value that you have set for yourself you begin to sell off small portions of the trade (Scaling out). Some traders do both. Some traders only scale in. Some traders only scale out. Generally this is an extremely powerful technique if you have a large portfolio and it would be hard to buy and sell your entire position instantly.
Hedging- This is by far the most complicated of the techniques listed in this article. Generally hedging is done using options. The idea here is that once you have bought some shares of a company you buy options in the opposite direction in case the trade goes against you. This will cut into your gains, but also reduces your risk substantially.
This might be a little hard to visualize, so I’ll try and lay out a scenario that might make sense. John Investor likes the tech company TECH and thinks they have a lot of room for growth, but is worried about a competitor pushing them out of the market, so John buys 100 shares of TECH at $55. To help reduce his risk he pays $4 a contract for 100 put option contracts which give him the right, but not the obligation to sell a share of TECH at $55.
This way if the stock goes south he can exercise those options and he’ll only lose the $400 it cost him to buy the options. On the other hand if the trade goes well he must first get to $59 to offset the $4 he paid for the options, and anything after that would be profit.
Risk management is obviously a fairly complex subject and their are entire departments of trading firms that do nothing but risk management and analysis, so don’t feel like you’re going to immediately understand how you should set your loss prevention system up. When I go over things like resistance and support in the next article you should have a much better idea of where these different techniques can be applied when you look at your next stock.