Appropriate Risk Management in trading covers several aspects. Below is a summary of the most important elements which will form the basis for your success in trading.
- Appropriate Risk Management starts with having a sucess proven strategy and the discipline to relentlessly stick to that during all market cycles. This in itself will put you ahead of most other traders, both amateurs and professionals. With proper risk management you will be able to make big money during bull markets and preserve your gains during bear markets.
- Before you enter a trade, you should know what your maximim risk / stop loss is. After entering the trade, accept and act when you are wrong and stick to your initial stop loss. Realize that trading is all about probabilities and not certainties, you cannot be right 100% of the time. In fact, you will be wrong 50% (or more) of the time. For traders, small losses need to be considered as costs for straying in business.
- The intital stop loss: your average gain should always be bigger than your average loss, ideally a factor of 2 should be applied. As you cannot fully control your gains, you need to fully control your average loss based on your average gain. If your average gain is 16%, your maximum stop loss should not exceed 8%. In general terms, your maximim stop loss should never exceed 10%. If a stock goes down 10% or more, something is fundamentally wrng with your analysis and stock selection, or the market is too volatile and/or bearish. Always get out of a trade at a loss of 10% latest, then step back, re-evaluate and continue
- You don not have to be involved in all market movements. No strategy works well in all market conditions. The fact that you can raise cash and stay on the sidelines provides oyou with a great advantage over large investment funds. When you realize that market conditions are unfavourable, do not try to switch to another strategy. Show the discipline to stay on the sidelines and watch the market until things improve. The time will come when your strategy fits well with the market conditions. Then it's time to get aggressive.
- Have a contingency plan for all scenarios. Before you go into a trading day, you should be prepared for any kind of scenarios, even if unlikely. E.g. what will you be doing if on eof your sticks gap down 20% on the opening? What if your broker platform goes down for whatever reason? What if your internet connection fails? Being preapred for all these scenarios will help you stay in full control of your trading.
- Position sizing: Your position sizing should be based on sound rules and you should always be aware of the risk associated with a single trade but also your overall portfolio risk. What risk are you running if all of your open positions would hit their stop loss?