1 You should always think about your potential loss before any potential gains.
2 You must be consistent in applying it and disciplined in sticking with it, one bad trade can really hurt you. One bad trade has brought down multi-Billion dollar trading firms.
3 A few things to remember
- A loss of 50% needs a gain of 100% to get back to break even.
-"When you find yourself in a hole, stop digging"
-"Only losers average down losing trades"
-Never meet a margin call with cash-sell the position
-If you lost your money in XYZ, why would you think that loser stock is going to make it back for you?
-"Money in a losing position cost more then just money, it costs opportunities"
-"If you have a trade you lost 30% on and I gave you the equivalent of what value was left in the position in cash, would you buy that same stock again right now?" If the answer is "No", then why are you still holding onto that loser?
-The market doesn't care where you bought your stock or how much you have lost, only you do. If you find yourself saying "I'll sell XYZ when it gets close to my buy price" you are doing yourself a disservice. You are holding that stock out of pure ego, because you don't want to admit you were wrong. It's like saying, "I lost this money here, I'm going to make it back here"
-NEVER DOLLAR COST AVERAGE A POSITION-You are throwing good money after bad. This is a myth that Wall Street has perpetuated so brokers can keep their clients and make more trades that cost the client more money and put money in the broker's pocket.
-Think about it, is that stock you lost so much money in really the strongest stock you could own right now to make your money back?
-When you are down, don't swing for the fences and try to make your money back fast-it almost always puts you in a worse position.
-If you are out of sync with the market, reduce your position size until you get back in sync with the market-this happens to all traders, we get hot and then run cold. You want to turn it up when you are hot and back down when you are cold, but human emotion wants to do the exact opposite of that-think about that.
-Drawdown is not the same as a losing position, draw down is a reality of any trend trading system and trend trading systems are where the money is to be made.
-Look at the big picture, do not chase every move in the market, it's designed that way to take your money. Instead, look at the big picture, use a 5-day chart and see if your plan still makes sense.
-If you can't take small losses, you will take large losses
Now, "The 2% Rule"
The idea is, you never want any one trade to cost you a loss of more then 2% of your portfolio's worth. However there are many different interpretations of this. If you trade one stock at a time then it's this easy.
Portfolio worth=$10,000 and 2% of portfolio =$200. So your trade, if you get stopped out, should not cost you more then $200. When I'm not in sync with the market or it's a speculative trade, I will reduce my risk to 1% or even half of a percent. If I'm on a huge losing streak I'll take a month off from trading.
Now, here's the problem-diversification. Very few people trade only one stock at a time. I recommend not trading more then 6-10 stocks, depending on how large your portfolio is. Wall Street talks about diversification and generally the number they talk about is 20 stocks. Do you know why? Because the financial products that most Americans own in their 401k or IRA accounts are Mutual Funds and by law, a Mutual fund must have at least 20 stocks in it. So to sell you on mutual funds, they have to sell you on "over diversification". That's right, it's too many stocks and why? Because with good risk management you don't have to worry too much about losses, but with too many stocks, you biggest performers barely move your portfolio. A stock that gains 100%, that only represents 5% of your portfolio can only give you a 10% gain and with the inevitable losses you will have with 20 stocks, that gain will be a lot less. You need enough stocks to have good market coverage and you can do that with 8-10 stocks.
So if we have a 2% rule for 10 stocks that means we have 20% open risk all the time-it's way too much. So here's how you handle it.
I have $10,000 and I feel comfortable trading 5 stocks at a time. 2% of $10,000=$200 of risk. I divide that $200 of risk among my 5 stocks. that would mean that each stock can carry a total risk of $40. You may be thinking, "So I buy 100 shares of a stock and when I lose $40 I get out?" Wrong. Now we have to talk about Position Sizing.
When I am interested in a trade, the first thing i want to do is determine my risk. When you enter a new position it is better to have a wider stop most of the time to allow the trade some time to work. So I found XYZ for $10. I see that there is a strong support level at $9.75. We know that the market likes to take out obvious support levels to hit stops so we say I will place my stop just under that support level at $9.50. You are buying a $10 stock, and your stop is at $9.50, now you know how much risk per share you have-$.50. You already know that you can't lose more than $40 in any one position so you divide your risk $.50 into your risk per position $40 and that gives you the number of shares you can purchase which is 80 shares.
Now suppose your stop is very close on this trade, it's at $9.90 (the stock still sells for $10), your risk per share is now only $.10 and that divided into your risk per position ($40) allows you to buy 400 shares. The only problem with this scenario is 400 shares at $10 will cost $4,000 which is nearly half of your portfolio. There's one type of risk that is very difficult to deal with and that is the gap in the morning, when a stock you buy falls because of bad news over night and opens much lower. If you have nearly half of your portfolio in a stock that gaps down 20% (which happens everyday) you just lost $800. That's 20 times your proper risk amount of $40. So I always try to keep my portfolio position cost at 15% or so. This is one of the few ways you can lessen the impact of a bad gap, but still have a position that is meaningful in size. Sometimes I may take it to 20%, but I have a high tolerance for personal risk. So what do you do when you can buy 400 shares, but it's too big for your portfolio, simply buy 15% of your portfolio. In this case you can buy 150 shares of that stock.
Some people prefer to use the 7 or 8% rule, when you lose 8% of a position you exit it. If it works for the stocks you are trading that is fine, but I personally think it is not an objective rule. What if the stock you are buying has an Average Trading Range "ATR" of 7 or 8%-meaning it can swing that much intraday? You can't trade those stocks, you will be stopped out for a loss every time. so I prefer to have an objective rule, maybe a support level, maybe a moving average....
Here's my solution, it's called my Trend Channel and it is another indicator I developed and received an award for.
The way the Trend Channel works is to use a moving average and then to automatically,for each stock, figure out the average volatility of that stock over a certain period of time-usually 20 days. then it adds a standard deviation above and below the center of the channel. So if the stock moves more than 1 standard deviation away from it's average volatility, I know something big has changed. In a long position, the bottom of the channel's highest point is the stop. Currently the red arrow at $237 is the stop today. In an uptrend, the Channel will lock in gains higher every day. I always stop out at the end of day closing price, that is why the green arrow did not cause a stop, because that was an intraday violation, not an end of day.
When entering a position I can look at the channel and get an idea of where my stop should be, but I consider all things when placing a stop. In a short position/downtrend, the lowest level of the upper channel is the stop at the end of the day. This system will never allow you to catch the top or bottom of a trend, but it will keep you in a strong trend with objectivity. Human emotion, fear and greed would have most people out of this trade at 20%, maybe 50% but then they become very afraid of losing their gain. This channel takes all that away and replaces it with objectivity, it knows how the stock behaves and when the stock does something out of character and crosses the channel, you know the trend is about to end.
So when choosing a stop, try to match your stop with the stocks trading habits, maybe it always holds a 50 day moving average in the past and that may be your stop or maybe it has big swings so you know you need to allow for them and by less shares. This is all part of risk management.
By the way, you decide how many stocks you want to trade and you decide how much open risk you can tolerate. Maybe it's not a 2% rule for you, maybe it's a 4% rule or a 1% rule. Maybe you only trade 3 stocks at time, it's highly individualized, but what I gave you is the standard format. It may seem a little conservative, you can change it to fit your style, but I can tell you by experience, making money in the market is about patience, good risk management, building your wealth not try to create it in a week and most importantly, protecting it because it is a lot easier to protect your money then it is to make it.
Please, just never move your stop away from where it should be because a trade is going against you. You must be disciplined for this to work, but if you are disciplined, you won't be upset about a 30% loss in your portfolio. You will gladly take a 2% loss when a trade doesn't work out and it won't bother you. And believe it or not, you can take 10 trades, be dead wrong on 6 of them, have two of them basically do nothing and have one or two that are like AAPL and you will build wealth.
Sit down with calculator (I could give you the answer, but find it out for yourself and it will really be exciting) and figure out how much money you can make in a year if you make 7% a month and compound it. For example-$10,000 is what you start with, you make 7% in January, it is worth $10,700, you make 7% in February and it's worth $11,449, then in March another 7%=$12,250 and keep on going for 12 months. You'll be surprised.
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