Investment Consulting

Wednesday, April 17, 2013

Risk Management Basics

Risk Management Basics

One thing that is certain in anyone’s trading career is losses. Even the best traders lose from time to time. What the best traders have in common, however, is that they are very professional losers. Knowing how to lose properly is a must in a long and prosperous trading career. This theme is also a key part of the Forex trading success. A big focus for us is how to reduce risk with three important tools. With the proper use of protective stop orders, proper position size, and simply keeping losses small, losing becomes a painless and simple part of a successful trading career.

Protective Stop Orders

Protective stop orders to the trader are as important as the oxygen tank to the Astronaut in outer space. Without them and proper use of them, you’re in big trouble. Protective stop orders in trading are meant to help limit your potential loss. There is more than one type of protective stop order and it’s very important that you understand the difference between them.

Stop Market Orders: This is an order to buy or sell once price reaches a particular point. Once price reaches a pre-defined price, the order becomes a market order. This type of order can be used to enter or exit positions. Typically, this order is used for protection. While execution of this order is typically guaranteed, the price at which the order is executed is not guaranteed. This is because the order being triggered is a market order. The benefit with this order is that you are guaranteed to be taken out of your position. The negative is that if the market is moving fast, you may see some slippage and not get filled at the price you desire. This certainly is the ideal order if your goal is to protect yourself. As a trader, I always use this order for protection.

Stop Limit Orders: This type of order combines the features of a stop order with the features of a limit order. Once a pre-defined stop price is reached, the stop limit order becomes a limit order to buy or sell at the limit price or better. The benefit of this order is that the trader has control over the price the order will execute at (it is “limited” to the stop price you chose). The negative factor with this order is that it does not in anyway guarantee protection which is what most traders/investors want in a stop order. For example, if you bought a stock at $41.00 and have a sell stop limit at $40.50 and price reached $40.50 but there are no buyers, price will keep declining and your loss will grow with no protection. In short, if you are looking for more guaranteed protection, the stop market order is a much better choice. As a trader, I NEVER use the stop limit order for protection.

Position Sizing

We can do some simple math to ensure we are not going to lose more money than we are comfortable losing by using proper position size. In this example, let’s assume we have an account with $100,000.00 in it and we decide that our maximum risk is going to be 1% of the account ($1,000.00). If this trading opportunity requires a $0.40 stop and we do the math, we see that we can buy 2,500 shares. This means that if the trade does not work out, we will only lose the amount of money we are comfortable losing, the $1,000.00. Having a position sizing grid like the one you see here when trading any asset class also helps your trading become more mechanical. The key is that you don’t want to be “thinking” executing your trades. You simply want to follow a logical rule based plan based at its core on the laws of supply and demand.

Keeping Losses Small

The cornerstone of  Forex Trading is risk management. Knowing how to minimize risk is the most important thing in trading. There are really only four possible outcomes to a trade or investment: A big win, a small win, a small loss, or a big loss. As long as we ELIMINATE the big loss, we can live very comfortably with the other three. So, the key is to follow your rules and the risk management will take care of the profits.

 As humans, we always want to be right, we hate being wrong. You can’t think this way in the world of trading and investing because the truth is, you will have losses. Embrace those losses as a part of your trading and keep them small. On the emotional side of trading, I don’t feel any different about a winning trade or a losing trade. Perhaps the fact that I have been doing this so long is a factor but the reality is, I am simply executing a profitable plan over and over and over.

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