The two key aspects to master as a day trader and/or long-term investor is the psychology and risk management. Getting over the psychological hurdles of trading is simply going to take time and experience. The risk management should be one of the first things you get down if you want to be successful over the long term. Managing risk trading or investing can be the one factor that makes or breaks your success in the market.
History Repeats Itself: Avoid Becoming a Statistic
We all have heard countless horror stories about people losing significant sums of hard earned money by an investment or trade gone bad. Most of these coming out of times like the Dot Com bubble or the crash of 2008 thanks to those infamous subprime mortgages created for failure. Those are just two examples of many crashes resulting in many people losing tons of money at the hands of the market.
From all the stories I’ve heard, at the heart of all the lost fortunes were poor or non-existent risk management plans. People would just put their money into whatever equity with no real thought into what if this doesn’t work out? How am I prepared for this company or the market as a whole running into disaster?
We all know in the market things can go south quick, fast, and in a hurry. With this simple oversight many people have loss literally everything on something as common as an inevitable market correction or bad news. Other than not participating in the market at all, there is no way around avoiding this risk. Rather you’re long-term investing, swing trading, or day trading, risk management is vital to your success in this unforgiving market.
So What is Risk Management?
Now when we talk amount risk management for trading what does that really mean? It’s quite simple actually. How much are you willing to lose on a single trade, in a day, in a week, or even in a month. The time frame really is up to you, but you need to know exactly how much you can personally stand to lose and still live to trade another day for as long as you desire.
Also, you need to ask yourself, “Is the amount I’m risking for this trade worth the reward?” There’s countless strategies and technique you can use to determine what your reward possibilities are, but conventional wisdom says the minimum risk to reward should be a 1:2 ratio. For example, if I’ve determined my risk to be $100, the trade is only worth taking if I have the possibility of making $200 or more without compromising my risk.
Remember you should never risk more than you are willing to lose. Many traders have failed from blowing out accounts due to little or no attention given to the risk. Losing streaks are inevitable for every trader. Having a solid plan will ensure you are able to make it through the storm.
How can a losing streak spell the end of your career or hobby as a trader? Think about this. If you have $5000 to trade, with a per trade risk of $100, taking 10 losses in a day can take away $1000 in one day! Repeat this and your account is down to 0 in less than a week.
Morale of the story? Beyond planning the risk per trade, part of your plan should also include how much you are willing to lose in a day, week, or month.
A good rule of thumb is your per trade risk should be no more than 5 percent of your capital. Ideally, you want to risk no more than 1 or 2 percent of your total capital per trade.
Developing Your Risk Management Plan
There are many sources on the internet and in books that cover what a risk management strategy for trading should look like. One of my favorite sources that I used to help develop my risk management plan is reallifetrading.com. I didn’t follow their strategy exactly, mainly because their main focus is on equities and currently I’m only day trading futures, but the core of the risk management technique is at the heart of how I manage my risk. The most significant part to me is the way they remove looking at risk in terms of an actual dollar amount since there’s typically a ton of emotion tied into money. Instead, when viewing risk they simply refer to it as an “R”.
As a quick breakdown, let’s say my risk tolerance (using the example above) is $100 per trade. Now, you can just replace $100 with 1R. So instead of saying I am willing to lose no more than $100 on a single trade, you say I am willing to lose 1R on a single trade. You can try to say this out loud for yourself and see if you feel different saying 1R instead of $100 dollars. Like removing the innate emotion from losing money. Like a way of tricking the mind by removing the fear from trading since we know fear is the root of all evil when it comes to trading the market.
You can even take it a step further now that you have the understanding of what your R is and make rules for how many R you are willing to lose in a day, week, or even a month before stepping away from your trading station depending on how you develop your risk management plan. I highly recommend checking out Real Life Trading’s educational content since it’s 100% FREE!
You Have the Control
Risk management is a key element to the success of every business. Every successful trader and investor agrees that participating in the stock market should be treated as a business. Contrary to popular belief, earning money from the market is not gambling even though there’s a lot of similarities and the rush you can get similar to that of gambling in Vegas. What separates trading from gambling is the ability to control your risk. Take charge of your business. It’s only as risky as you make it.
P.S. Averaging down = no good!!!