Having risk management rules in stock trading is critical to help keep your trading losses to a relative small amount and to also help preserve your trading capital. It has often been said that risk management when trading is one of the most important elements for traders to contend with.
Managing trading risk is something that you can control as a trader, unlike that of price movement, which is something that you can’t control.
It’s important that your risk management rules be documented in your trading plan and be followed with disciplined.
A Risk Management Plan Should Include
1) Allocation of Trading Capital – determining how much of your total trading capital should be allocated in doing just one trade. Don’t risk all of your trading capital to just one trade which is more like taking the gamblers approach.
2) Maximum Risk Per Trade – determining the maximum loss willing to accept for each trade before having to close it out. This will help to ensure that small losses won’t turn into much larger ones.
Popular Ways To Manage Trading Risk
1) Stop Loss Orders
Using stop loss orders are common among traders to help protect them against losses that could either quickly or emotionally become spiraling out of control. Although setting stop losses can be a little subjective depending on the risk tolerance and objectives of the trade, they should never be set to exceed the maximum risk you are willing to accept.
Stop Loss “Rough” Guidelines
Swing traders will usually have tighter stop losses in place compared to trend traders and position traders due to the smaller profits trying to be captured within a shorter time frame. And, day traders will definitely have tighter stop losses in place out of all the other types of trading styles.
The following are “rough” guidelines as to how a hypothetical trader engaging in the following trading styles might be willing to accept as the amount of trading loss to tolerate:
- Trend Traders and Position Traders may be willing to accept 5% to 10% trading loss
- Swing Traders may be willing to accept 3% to 6% trading loss
- Day Traders may be willing to accept 1% (or less) trading loss
Here is what one legendary trader and investor has to say about how much loss to tolerate before exiting your position –
“Cut all losses at no more than 7% or 8% below the buy point, with no exceptions, to minimize losses and to preserve gains”
– William O’Neil
Founder of Investor’s Business Daily
Creator of the “CANSLIM” Formula
This is definitely great risk management advice by the legendary Mr. O’Neil. However, it would be more applicable to longer-term trading styles like trend trading and position trading (or possibly swing traders that have a longer time horizon and larger risk management rules) where possible smaller adverse price swings would automatically be accommodated in the hopes of achieving larger price moves from these types of trading styles.
Setting The Stop Loss – It Really Depends On You
The amount of loss that you are willing to accept when placing your stop loss order really depends on you. Here are some suggestions that you may want to consider:
- Should not be more than your maximum risk tolerance you are willing to accept according to your trading plan.
- Depends on the type of trading style you will be doing (see above)
- Trading price range occurring within the time frame being traded
- Technical analysis (see below)
Technical Analysis – Insight For Setting Your Stop Loss
A solid understanding of technical analysis and knowing key areas on a chart will serve as an invaluable asset to best position your stop loss order. This will help you to strike a happy balance between giving your trade enough breathing room to move about while at the same time keeping your maximum risk tolerance rules intact.
TIP: what is probably more important than just setting your stop loss to a certain fixed percentage (like 5%) is the relative “technical” location of it. Once you have decided on your stop loss for a trade, then ask yourself – “does it sit well on a chart using your favorite methods of technical analysis?”
For example:
- Is the stop loss order in a likely impact zone where it might get triggered too soon?
- Where is it in relation to strong support or resistance areas?
- What type of candlestick (or small cluster of) is closest to where you want to place your stop loss?
Keep In Mind
If the stop loss is placed too tight, you run the risk of getting bounced out of your trade too soon. On the other hand, if the stop loss is placed too loose, you run the risk of accepting a greater loss beyond a reasonable amount from what your trading plan may suggest as to your risk management rules.
Your open stop loss orders in the market will automatically serve as your protective “watchdog” to get you out of harms way – even if your computer isn’t turned on or you are possibly even on vacation.
Remember, stop loss orders are flexible and can easily be adjusted at any time during the trade to manage trading risk as well as to lock in profits where trades are moving favorably.
2) Trailing Stop Loss Orders
This kind of order is somewhat of a close cousin to the stop loss order explained above.
However, unlike the stop loss order, the trailing stop loss order will automatically adjust itself after the stock moves in the direction as you have expected.
You can set your own trailing stop loss criteria as to how far away or close you want this order to trail behind the actual stock price.
If, however, the stock moves in the opposite direction than you had expected, the trailing stop loss order will not adversely adjust itself to put you in a worse loss position.
Caution Note: stop loss orders are subject to “GAP” risk.
Example: You bought a stock at $30 and put in a stop loss order at $28.50 (5% below the buy price). The stock is currently trading at $31 (you are in profit by $1), but after the market closes the company announces poor quarterly earnings and furthermore lowers revenue and profit guidance going forward. When the stock of this company starts trading again the following morning it gaps down and opens up at $27.90, a 10% hit from the previous days closing price of $31. You will get stopped out of your trade at the next available price starting from $27.90, but due to the high volatility and panic selling among traders your trade settles at a stop loss price of say $27.65. Because of this gap in price, you did not get out of your trade at your stop loss order originally set at $28.50, but instead where it settled at $27.65.
ADVANCED Risk Management Strategies
Hedging Techniques
Advanced risk management strategies can include hedging techniques such as using stocks, etf’s and options which can take an offsetting side to your current trading position.
Example – Hedging with Options: if you buy a stock, you could then buy an at-the-money put option to hedge against any potential losses resulting from a decline in that stock’s price. As a result, if the stock price starts to decline in value, the at-the-money put option will start to gain in value.
Tip: To reduce the cost of hedging with an underlying put option, you could partially, if not fully, offset this cost by selling a somewhat out-of-the money call option.
If you have a broad based trading portfolio consisting of multiple holdings, you could find a correlated broad based index fund that closely matches your trading portfolio. You could then use the appropriate underlying put options of such index fund to hedge against any losses that may occur against your trading portfolio.
Example – Hedging with Exchange-Traded Funds (ETFs) if you own a diversified trading portfolio that you don’t want to immediately sell because you believe that high market volatility will be coming soon, you could use a closely correlated exchange-traded fund to “short” or even buy a closely correlated inverse ETF fund to mange trading risk.
Summary – Risk Management When Trading
Having rules in place to manage trading risk will greatly help you to keep your trading losses to a relative small amount and to also help you preserve your most precious asset – your trading capital. This is what professional traders do religiously!
