Trading stocks is nothing more than managing our risk. It can be a really complicated subject but I want to keep it as simple as possible. If you haven’t already found out, in order to make money trading stocks, you need to risk money. As traders our goal is to take as much of the risk out of the trade as possible and there are several ways to do that. Over time your risk assessment on trades will become easier and faster and won’t take much time to calculate.
- Determining your max loss.
- This is your best place to start, how much can you afford or want to lose? Everyone should have a max stop loss on every trade you enter. That will determine your share size.
- example: If you’re looking at a stock XYZ that trades at $10.00 per share. You determine your max loss is $500. So you can buy 1000 shares($10,000) and you would have to sell or stop out at $9.50.
- Determining your loss in reverse.
- This is a more technical way to determine your share size to manage your risk. Most traders find areas on the chart to sell at important resistance or moving averages.
- example: Stock XYZ is trading at 10.00 per share, however after studying the chart you determine that 9.00 is a key resistance if the stock breaks below that you will sell. You can easily figure out your share size now, using the $500 max loss above, you can now only buy 500 shares of XYZ. That will give you room all the way to 9.00 before you hit your max loss.
- Adjusting risk.
- It’s possible to adjust risk while in a trade by two ways; Add to or Sell part of the position.
- Adding or selling can reduce your exposure and also lock in profits.
- You can either add to or sell part of a losing or winning position to lower or raise your cost basis.
- example: Stock XYZ is trading at 11.00 after you buy, you decide to sell half your position and lock in profits. If you place your stop now at your original buy price, you’re locking in a profit and also reducing your risk.
- example: Stock XYZ is trading below your cost at 9.50, you’re .50 away from stopping out at 9.00 but you still like the chart and believe it could turn positive. You decide to add to your position, however this now adds more risk and will effect your stop loss. Now you have 2000 shares at an average of 9.75 (you bought 1k shares at 10.00 originally, then added 1k at 9.50). If you maintain your original stop loss goal of $500 now you will need to sell or stop out at 9.25.
- Setting profit targets.
- Just as you set your stop loss you can also set a profit target. Many traders will look at the profitability of at trade by looking at the potential profit versus how much you’re risking. This can be determined by your own trading style and risk assessment.
- example: You determine that stock XYZ has a good probability that it could hit 12.00 with resistance still at 9.00. There is more profit potential than loss built in. Its a 2:1 ration. If the stock hits 12.00 with 1k shares, you would profit 2k vs stopping out at 9.00 for 1k loss.
- example: If stock XYZ only looks good for a 10.25 profit target and still 9.00 stop loss, your profit ratio is not that great. In this case I would consider a tighter stop loss to at least give you a 1:1 ratio. Profit target 10.25, stop 9.75.
- Manage your own risk, not others.
- Many of us work other jobs and utilize services to help us with trade ideas. Don’t blindly follow other traders risk! You need to calculate your own risk on every trade. Many traders have different levels of risk so make sure you’re looking out for yourself first.
Practice, Practice, Practice! This is very basic stuff to understand but it will take a little time to master it. Once you understand the basic theory you will be able to try different techniques and strategies.