How to Manage Risk Trading Stocks
When any trader makes a decision to buy or sell (short), they must also decide at that time how many shares or contracts to buy or sell as well. The essence of risk management is making a logical decision about how much to buy or sell when you choose how many shares you want to trade. This decision determines the risk of the trade. Accept too much risk and you increase the odds that you will go bust; take too little risk and you will not be rewarded in sufficient quantity to beat the transaction costs and the overhead of your efforts. Good money risk management practice is about finding the sweet spot between these undesirable extremes. If you risk too little on each trade, the returns will be too low to overcome transaction costs, small losses and overhead. Risk more and the returns will increase , but note that the potential draw-down always increases as you increase the per-trade risk. Returns continue to increase moving into the over-trading zone. These are crucial Risk Management basics.
Understanding Trading Risk Management
It’s easy to determine how much risk management there is in a particular trade. The first step is to decide — before you put the trade on — at what price you will exit the trade if it goes against you. There are two ways to determine this price level. The first is to use a trading method based on technical analysis that will provide a reversal signal or a stop-loss price for you. The second is to let money management determine the exit when you don’t have a technical or fundamental opinion about where the “I was wrong” price point is. This is where you draw a line in the sand and tell the market that it cannot take any more money out of your wallet. It is important to watch your positions as they progress and adjust your stop prices as the market moves in your direction.
Take your losses when they are small because if you don’t they are sure to get large. In this regard, discipline is of the highest importance. It is a cardinal mistake not to take a stop if it is hit. It’s even worse if the stock comes back and turns the trade into a winner because now you have been psychologically rewarded for making the mistake.