Risk Management Made Easy

Risk Management Made Easy

Let’s talk about risk management.

I get a lot of questions about my choice regarding risk management. The style of the system I have come up and my numbers, are often criticized, but it’s how I do it and it makes sense to me. But most importantly, my system works for me and plays a massive role in my trading plan.

Let’s start with my account break down.

For simplicity reasons let’s say I have an $10,000 account. The number 1 rule of risk management is to never trade your entire account, like the saying goes never put all your eggs in one basket. Same deal here. So what I do is divide my account into quarters.

So if I had 10k I would only allow myself to trade 2,500 per trade. Obviously this number would change if I made money and wanted to readjust for the next trade. But I do this in case the stock goes bankrupt or goes away, and/or worst case scenario: if I lose everything I have in that stock, the most I could possibly ever lose is 25% of my account or in this case $2500.

Now when trading larger stocks, losing everything is highly unlikely, but none the less, it is possible. I also only use 25% because I think trying to manage more than 4 positions at one time is too much and allows more room for mistakes. It’s difficult to be able to follow what is going on at the same time with more than 4 positions at once too. And to be honest I hardly ever have more than 2 trades at one time going on anyway. If you’re just starting, do yourself a huge favor and don’t trade more than 1 at a time. The market isn’t going anywhere, don’t worry.

The Ratio

The next part of my trade management is the 3:1 risk ratio. You can do 5:1 but I stick to 3 because I’m not greedy and I like to cash in while I’m ahead. It’s ok in risk tolerance, but I tend to want to get out quicker. What I mean by this, is you risk 1 part to try and gain 3 parts. In my case, the parts are percentages on my account, not the stock I’m trading. That’s very important to remember. So my winning trade would be a 3% gain on my account and a losing one would be a 1% on my account. I’ll get more into that in a minute.

The reason that I choose 3:1 is because I break my account value into fourths. I then would theoretically trade 4 trades. If I were to only “win” one trade and lose 3 I would break even for that period. The only way I would lose money is if I was wrong in all 4 trades. Which is possible, but unlikely especially with good research ahead of time. You see I set myself up for losing, a hedge if you will.

Minimize Losses

Now back to the 3 and 1% figures. The reason I do 1% of the account is in the instance I am wrong and the trade goes against me, I will only lose 1% of my account. So if I’m wrong on a 10k account I still have 9900 left to trade. It’s like flight or flight mentality, you can stay and fight a losing battle (you will never win against the market once you’re against the market, you better exit or be prepared to lose) or run away and live to trade another day. This helps prevent blowing your account which plagues most trades (about 90%). Happens to everyone including me, that’s why I came up with this system and these numbers. I got real tired of funding my account because I was making stupid trades. Everyone makes dumb trades, you just have to get away from it and cut your losses as soon as you realize it was dumb.

Now the only time I would ever advocate using more than 25% of your account or make a trade is if you have less than 1k, but I would never trade more than 50% in one single trade. I say this because it’s hard to even get any momentum if you are only allowing 250 per trade on a 30$ stock. I mean you’re making peanuts if you stick to the 3:1 rule which you should, but this will allow you to increase your trade size. If this makes you nervous then use 25%.

Make Your Own Rules

You should make your own rules, this is just what I do and guidelines that I have for myself. But if you are that nervous you should probably be paper trading. I actually advocate this until you get familiar with the market and trading. Not knowing how different order types are handled through your broker can cost you $1000’s if you don’t keep it under control. (I’ve also learned this through experience.) All the money lost and mistakes I’ve made in the past were 100% my fault and not the market or my broker. One time is I didn’t understand the broker’s platform well enough and my stop was never hit and by the time I checked my account I was down more than I care to share. All because I didn’t set it up correctly with the broker. I called them I worked it out and they gave me a rundown of where I went wrong and how to avoid it next time (but didn’t get any of my money back.)

My point is, don’t get discouraged when you start if you lose or make mistakes, it happens. Just realize about 90% of the time it’s probably your fault and it’s something you missed. I know it’s a tough pill to swallow for some, but the mentality and mindset of being able to accept when you’re wrong will help you become a successful trader.

Risk Management By Greed Management

Also by knowing you are getting out at 3% and getting out at 1% if it goes against you, you will know your exact entry and exit points price wise. Back to the 10k example, if you had a 5 dollar stock you would allocate $2500 of it for a 500 share trade. If you got in at $5 your 3% exit would be 5.60 and your stop/loss would be $4.80. Your potential profit for the trade would be 300 and potential loss would be 100. See how no matter what the stock price is you risk the same dollar amount because it’s based on your account value and not the stock’s value. This way you can have more predictable trades by having this plan in place you can focus your energy on the analysis and stock scanning.

To help ease the stock analysis you now can look for stocks that look like they only have moves fitting your 3:1 ratio. Like from above, if you look at a chart and the stock is currently at $5 and it doesn’t look like it can make the move to $5.60 you know you’re better off not taking the trade. Sometimes the best trade is the one you don’t take. But that’s a different subject for another time.

I have made a calculator to help you with this risk management, it calculates everything for you above you only need to enter two parameters. Go check it out at here.

This is a great way to cover  risk management with your trading, by far not the only way. But it’s a way to help you get started with it. Please let me know if you have any problems or questions I’d be glad to help.