This is one of the easiest trading concepts to learn, but one that too many traders ignore.
This often leads to huge losses or even blown up accounts. So do yourself a favor and take this day’s lesson very seriously.
The Concept: Managing Risk
Risk management is the most important aspect of being a professional trader.
In fact, it’s so important that when I get asked “what do you do”, I often answer that I am in risk management.
Risk management is so critical that I argue that if you did not know anything about the stock market, technical analysis, setups or stock picking, you could beat most traders just by understanding how to manage risk.
What do I mean by risk?
I am talking about the probability of losing your trading capital, which is the lifeblood of any trader.
In other words, it’s how much you can potentially lose.
I think of risk in two ways: on a macro basis, and a micro basis.
The macro is how risk impacts your overall account.
The micro is how risk impacts a specific trade (which in turn impacts your overall account).
Today we will focus on the micro, setting stop losses for individual trades.
Tomorrow we will discuss macro risk management on a macro level.
After talking about protecting the downside, we will then focus on rewards, or profit targets on day 6.
Finally on day 7 we’ll put it all together with the concept of “reward to risk” ratios.
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How to Effectively Set Stops to Protect You Account
A stop, or stop loss, is the spot where you will get out of a trade and take your mask loss.
For example, if I buy 100 shares of NFLX at $367, I could potentially lose a maximum of $36,700 (my total position cost) if the stock went to zero. Obviously, we would never let that happen.
Instead, we place a stop at the level we are willing to lose. If we set a stop loss at $347, we would lose a total of $2000 (100 shares X $20 = $2000).
When placing a stop, we need to think about three different things:
- The maximum we are welling to lose on this trade
- Where the stop makes sense in the stocks price action and chart
- If the position sizing makes sense for us to take the trade.
The max you are willing to lose on a trade depends on your account size and your risk management on a macro level (we’ll discuss this more tomorrow, but for now let’s assume we are willing to lose 1% of our account per trade).
The stop placement on the chart depends on price action support and resistance levels, and areas that aren’t in the stocks’ natural volatile movements.
When thinking about position sizing, think about how much the reward needs to be to make this trade worthwhile (we’ll talk about reward on day 6, but for now it usually should be at least double your amount risked).
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Source: bullsonwallstreet.com | Original Link