Risk Management

Most, if not all traders, will go through a phase where they take a huge loss because they let a small loss get out of control, then hope it reverses, tell themselves they’ll sell at breakeven, only for it to dump further. Once it reaches the point where the pain is too great, they sell. And then of course, what happens? The stock instantly reverses. If this sounds familiar – don’t worry. We’ve all done it. I know I have.

The problem with large losses is that they exponentially work against us. A loss of 15% loss requires 17.65% to get back to breakeven. This is acceptable, as stops less than less will result in a significant whipsaw and stops hit. A loss of 20% requires a gain of 25% to get back to where we were.

However, a loss of 25% requires 33%. A loss of 33% requires 50%. A loss of 50% requires 100%!

The problem with large losses is that you are constantly fighting a greater force – the power of numbers work even harder against you.

Most traders (and even investors) spent a lot of time on their analysis and entering a stock but they do not have a robust plan for getting out of that trade. This means we are vulnerable to our own emotions and can sometimes do something we regret. To prevent this, it makes sense to create a detailed contingency plan for exiting the position at a time when the markets are not open. By doing so, this removes the emotional pull of the market and its constantly changing prices.

Everyone only ever buys a stock for one reason: to make a profit. Sometimes, that goal won’t be achieved, but we should be focused on the long term and not so emotionally involved in that one trade working. To ensure we remain profitable in the long run we need to manage our risk. Here is a basic template for next time you open a position:

Check the chart and look for obvious support points

Ideally, we want to buy buying as close as we can to support. This is because we want to be as close to the danger zone as possible – if support is at 40p and we would exit the trade at 37p why would we want to be buying at 45p? That would mean we are risking 8p on a share; if we buy at 39p we are wrong at 37p and are risking 2p per share.

If our target price would be 60p we have cut our risk/reward ratio from 8/15 down to 2/21. However, risking 2 to make 21 will result in plenty of small losses as we are repeatedly stopped out, so to make the trade more realistic we should have a lower profit target. By doing so not only are we entering the trade at a price much more favourable to us, but by cutting down the reward target we are also increasing our chances of staying in the trade.

Adjust your position size for risk

If you keep your position sizes constant, but your stops are at 5% and 10%, then you stand to lose double on one trade than the other! This may be fine if the risk/reward ratios are set appropriately, but to keep risk constant we can adjust our position size for risk.

Let’s say you are comfortable with losing £500 on a trade size of £5,000. This is 10%, or R. R is the risk you are taking on the trade, and we want to keep R constant.

Imagine the trade you are looking at would require a 20% stop due to the spread and illiquidity. This would mean a loss of £1,000, which would be 2R – not what we want!

Instead, we can cut down the trade size from £5,000 to £2,500. A 20% stop on £2,500 would result in a loss of £500, our preferred R.

To calculate our required position size, we take R and divide it by the percentage stop we require. In this instance, our R of £500 would require a 20% stop, so we compute 500 divided by 0.2 and we get 2,500 from our calculator.

Know where you’re getting out

Hit and hope strategies don’t work in investing, and they don’t work in trading either. Hope isn’t a real strategy – ideally we should know where we’re getting out in every trade.

Contingency planning will help to remove doubt. Stock gaps down on a profit warning? Stock sells off through support on large volume? Knowing what we will do will improve our results in the long run.

Write it down and set alerts

The best way to hold accountability to oneself is to make the decisions on your trades outside of the market hours and then write it down. Once your plan is written down, do your absolute best to follow it. Most traders don’t plan, and most traders don’t make money. There is a strong correlation here and it is a direct cause and consequence. Like in many things in life, failing to prepare is preparing to fail.

I used to think that I made so many trades I didn’t have time to document them, but the reality is I was trading too much and making too many excuses. Once I started judging my results entirely as a result of my own actions this forced me to be accountable.

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