What if I were to tell you that 70% of my trades were losers and only 30% were winners but I was still very profitable in my account. Would you believe me? Most would say that would be impossible with those kinds of percentages and immediately call me a liar.
When people read the title of this article they are going to think the holy grail of trading is some type of money making strategy that will get you 50000% returns on your investment. If that was your thinking, then I’m sorry to disappoint but remember trading is a marathon not a sprint! So what IS the holy grail of trading?? It’s not a hot stock tip, it’s not insider knowledge, it’s RISK MANAGEMENT.
Businesses practice risk management all the time. They implement tools, policies, and procedures to protect themselves. If a business does not have a risk management strategy you can almost guarantee that they will not be in business for very long. The same thing applies to your trading! If you blindly buy stocks without having a way to protect yourself from downside risk, then you will quickly be out of money! (Out of business).
Let’s take McDonalds as an example for a company. McDonalds make a great deal of their revenue from the Chicken McNugget. Say a new disease breaks out worldwide that kills 80% of the chicken population. Let’s call it Pollo-berculosis. Anyway, if McDonalds doesn’t have a risk management plan in place then this could end up crippling their sales revenue for years! Although Pollo-berculosis was nothing anyone could have expected, McDonalds still needs to have procedures in place to protect its company if it wants to have a sustainable future.
What many people don’t understand when they get into trading is that you WILL lose money on some trades. It doesn’t matter how many years you have traded or if you have done all the research in the world on a particular stock, some trades will still turn out to be losers. The key to overcoming this is risk management and is one of the most important lessons I can teach you.
When most people buy a stock, they do not take the time to think about how they are going to exit the position. The thought is simply, “I’ll buy this stock right now and I will sell it once I make a great deal of money.” That seems like were falling under one of the common pitfalls of trading, buy and hope, doesn’t it?
Think of yourself as a bank robber when you go into a trade. Are you just going to start a hostage situation at a bank and steal a bunch of money with no getaway plan?? Of course not! You’re going to have a detailed escape route in case things didn’t go as you expected.
The same can be done with your trading. Remember, we are not fortune tellers. We cannot predict the how high a stock is going to go or how low it is going to go. Before I go into any trade, I think about the worst case scenario and ask myself, “what is the most I’m willing to lose on this trade?” It can be a percentage of your investment or an exact dollar figure; it does not matter. It will vary with each investor based on their particular risk tolerance. (some people can handle money fluctuating in their account more than others). Once you decide on this number you will know what price the stock will get to in which you will exit your position and not risk any further downside. If you remember from one of our last lesson you can insert a sell stop order also known as a stop loss to protect yourself and allow you to do other things besides watch your investments all day.
An exit strategy is like making a budget, you set it and don’t budge. In trading you want to be as robotic as possible. Keeping things automated and sticking with your stop loss that you have calculated will ensure that you do just that. On the flip side, when you do have a winning trade you need to decide when you would like to take your profits or place a sell stop so that you protect your profits if the stock price starts to retract. The use of technicals on the stock charts and research you have done on the stock will help you make a decision on where the price is heading. This will also get easier for you over time with more trades that you do. Human psychology will tell us that losers will rebound. We will refuse to accept that the trade is lost. You will say things like “It will turn around” or “this has got to be as low as it’s going” and we hang on to those losers causing losses to compound. On the flip side when we have winners we are too eager to take a profit no matter what it might be so we usually sell out too early. For these reasons, that is why it is best to always stick with your exit strategy no matter what. By using this strategy of cutting losers off quickly and letting winners ride, you are able to generate a profit in your account. Like I said 70% of my trades are losers and 30% are winners but my winners are BIG and my losers are small.
Many people buy into stocks and aren’t aware of how much risk they are actually taking on. There is the common saying that goes, “More risk, more reward.” I’m here to tell you that is a MYTH. Whenever I get into a stock trade I want my reward potential to be at least twice as much as my risk. In fact, 3-5x is more like it. Another saying goes. “You have to risk a lot of money, to make a lot of money” Again I completely disagree with this statement. I have made successful trades for thousands of dollars and only put up 500 of my own money in the process. Let’s look at an example of risk reward by looking at Elli Lilly stock.
As you can see Elli Lilly stock has form a clear support and resistance level from what we learned in our previous lesson on technical analysis. I want to buy Elli stock if it breaks the resistance level because I believe the price will have a bullish(upward) breakout. Let’s in order for this to happen Elli needs to hit a price of 76.50. I believe that if it does touch this price, it will go up about 2% from there and that is that profit I want to take on the trade. If things don’t go my way I will only want to risk losing 1% of my money. What is our risk/reward on this trade? 1:2. We are risking 1% in order to try and make 2%. Now don’t get this twisted. I believe that Elli will go up 2% based off the technical charts telling me it is breaking the resistance price. I am not blindly thinking it is going to go up 2%. There’s a big difference!
So let’s say we have calculated these numbers and we are ready to go. We want to invest $5,000. We put in a limit order (remember limit order guarantees you price) for 65 shares (5,000/76.50) at 76.50. Elli touches that price and we get filled. Great! Now we own Elli Lilly stock. We then put a sell limit order for 78.03 (2% profit exit) as well as a sell stop order for 75.73(1% stop loss exit). Now we can sit back and let this trade play out! If it works how we want Elli will climb to 78.03 and our limit order will trigger and we will get a profit of approx. 100 dollars. If we are wrong and Elli begins to decline, we will exit the position at our stop of 75.73 94 taking a loss of approx. 50 dollars.
Never settle for less than a 1:2 risk reward ratio. Anything lower than that is a gamble in my opinion and not worth your time!
Diversification is a very broad and important topic that I will be covering in many lessons. It’s one of the biggest keys to being successful as you continue to grow your account. For today I’m just going to cover the basics.
Diversification is simply not having all of your eggs in one basket. As you continue to grow wealth over time you will want to be invested in a variety of different stocks that are within different industries to spread out your risk. For instance, let’s say you had 100k in your account; generally, you would not want to take all of that money and invest it in one company. That way if that company takes a hit you don’t lose a significant part of your investment. In my experience as a broker, I spoke with numerous clients who add lost a great deal of money because they had it all in one company and had no exit strategy. Any company can take a huge hit at any time. I don’t care if its Apple or Facebook or even Starbucks. Spreading your risk out is key so we can avoid taking huge loses.
In addition to this you need to be aware of what industry your stocks are invested in. Using the 100k from the previous example, instead of investing in one stock you decide to invest in 5. Congratulations, you have just spread out your risk but what you failed to realize is that all 5 stocks are within the same industry. So now even though your risk has gone down from investing in 5 different stocks, it is still very high because they are all within the same industry. If that industry is down, then they will mostly likely all be down as well. It would be like if you went out and bought 5 Oil companies and then Tesla takes over the world of cars causing America to all use electric. Your account would drop significantly in value because all of those stocks in that industry would be negatively affected.
You might be thinking to yourself, “well how much money should I invest in each stock if I want to be diversified?” That’s a great question and really comes down to what the size of your account is and what your risk tolerance is as well. First, if you have a smaller account to begin, like 1k or 5k, something like that, then you’re not putting a lot of money on the line to begin with so it would be unnecessary to invest in a variety of different stocks. When you continue to grow your account the amount of variety you put in really depends on your risk tolerance. Think of risk tolerance this way. My friend and I both buy the same amount of Apple stock. Apple takes a hit and were both down 2 grand. I am comfortable seeing this kind of loss and hold onto the stock but my friend is not and he sells his shares, taking a loss.
Some people cannot take money fluctuating wildly in their account. They can’t stomach it. So really you have to ask yourself, “how comfortable am I with the swings in stock prices?” If you can’t stand it then you might want to diversify into a wider range of stocks to spread out your risk.
As you grow your account think of it as a pie and each of your stocks is a piece to that pie. Let’s say your pie is 50k and 50% of your pie is in one stock. If that stock were to take a drop, then a big portion of your pie would be eaten! We want our pies to get bigger, not smaller.
There is much more we will get into on this topic but if you can begin to master these risk management techniques, then you will avoid making a lot of mistakes that so many novices get into in their first years of trading. These techniques will also save you lots of money!
“Losers react, Leaders anticipate.”
Homework: Click on the link below and take the risk tolerance quiz to give yourself a better idea of how you would handle swings in your account value. Think about how much money you would want to put in one stock position, knowing that it could swing 2% up or down on a given day.