By: Ian Cooper
“I had no idea the stock would fall like this.”
My friend's e-mail read like a frantic trader that risked too much. “I just lost $5,800 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 investors. 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 it 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.
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.