The most important component to a trade or investment plan is the part on how to manage risk. When planning to engage the market many investors and traders put too much emphasis on the setup and entry and not enough on how they will manage the risk of being wrong. You see this not only in the behavior and communications of individual traders or investors but also throughout the media.
Success in the market is not about accurately predicting the future. It comes from recognizing that you do not know what is going to happen to a stock, sector or market in the future, period. No matter how good your analysis is and how certain you might feel, you do not know. Therefore, you have to always be prepared to be wrong about a position and have a plan of how you will take losses. The key is to determine when you are wrong as quickly as possible and to lose as little money as you can without missing an opportunity to profit.
No one can be smart enough to consistently pick winners. Having losers is part of the game. Expect it and plan for it. Everyone would like to have an 80% success rate where 80% of their trades are positive, but that’s not realistic. You can still make money overall with a 55% success rate for example, as long as the amount of your average winning trade is some multiple of your average losing trade.
How can we control risk?
As a general rule most professional traders would agree that you should never risk a loss of more than 2% of your account equity on any one position. Let’s say we have a $100,000 account. Then the maximum loss allowed per position would be $2,000. Keep in mind that this is the maximum loss. Many traders would and should use a lower maximum loss percentage so the risk to their equity is lower. For our discussion we’ll assume a 0.50% maximum allowed loss of $500 per position.
Maximum Loss Per Trade
Another part of a risk management strategy is determining the maximum loss per position. William O’Neil, founder of Investor’s Business Daily suggests a maximum loss of 7% for active investors and swing traders. A trader can use this as a guide and adjust downward according to their account size, skill level and comfort level. We’ll assume a tighter maximum loss of 5%.
Remember that a key to success is having a lower average loss per position compared to winners. This means that large losses cannot be tolerated. Your plan must have a strategy for keeping losses relatively small. What kills performance is having big losses – a position that “gets away from you.”
Now, let’s take a look at a live example for next week and see how the above metrics can be used to determine position size and also how to add a strategy to protect profits. The emphasis on this trade plan is not the quality of the setup, but rather the implementation of a risk management component to the plan.
Risk Management Plan – Seagate Technologies
We’ll use Seagate Technologies as an example. Last week the stock got hit hard, falling 12.7% to end at $42.13.The low for the week was $41.20. With that low Seagate reached a potential support area consisting of the 61.8% Fibonacci retracement ($41.49) combined with the 200-day exponential moving average (ema), now at $40.82.
The trade plan is to buy Seagate if it pulls back to $41.60 in anticipation of a bounce. An initial protective stop will be placed $0.20 below the 200-day ema, which is at $40.62. The risk on the trade is therefore $0.98 or 2.4%. That’s well within the maximum allowed loss per trade of 5%.
Next we need to determine the size of the position. Let’s start by assuming the maximum allowed loss of $500. If a $500 loss was 2.4% from our entry, we would need to allocate $20,833 to the position (500/0.024). That amount of capital would allow us to purchase 500 shares at $41.60 (20,833/41.60). Determining a profit target, another part of a comprehensive trade plan, will not be covered here.
Protective Stop: $40.62
Loss per Share: $0.98 or 2.4%
Total Potential Loss: $500
Next, we devise a plan for protecting profits. This can be done in a number of ways but we’ll only look at one. The first step is to move our stop to breakeven once we’re in profit. At that point we cannot lose money and our risk of loss is essentially zero, baring a gap open against us and execution slippage. We’ll do this once the profit is over 2.4%, equivalent to our initial downside risk. Then as the profit increases we’ll raise our stop and follow price up based on the price structure in the chart.
Implementing an active risk management plan is part of any prudent plan when engaging the market. The discussion above looks at the process of arriving at a plan. The details can be adjusted according to the requirements of the individual trader or investor.