I hope you're all doing well in your investing adventures. This post about managing risk is aimed more at traders than investors, but even if you're not a trader I believe that understanding the concepts illustrated here can help you make better investment decisions, so I recommend reading it anyway.
If there is one thing that is guaranteed to prevent a person from being a successful trader, it's too much emotion. As I transitioned from long- and mid-term investing to short term trading I struggled with this myself. I actually still struggle with it a little bit, so this post will also serve as a reminder to myself of some of the ways we as traders can use systematic risk management to manage our emotions and be more successful.
The first thing to understand if you are to really grasp this concept is which emotions are most likely to tear down your success. While there are of course many emotions, there are two that stand above all when it comes to preventing you from being successful in this business: FEAR and GREED.
On one end of the spectrum we have our ingrained fear of losing money which often prevents us from being invested period. The rationalization is that if you never invest, you absolutely will not make money in the market, but you also absolutely will not lose money in the market. This rationalization makes sense on the surface, but if you look a little deeper you will see that there is a glaring flaw: Cash depreciates in value and prices rise over time. Even though you might think you are protecting your cash flow by keeping your money in cash and not investing it, you are actually guaranteeing that you will lose money over the long term as prices inflate and the value of your cash (no matter what currency) depreciates.
On the other end of the spectrum we have greed, which really is just another type of fear: the fear of not making as much as you could have on a given trade or investment. Greed can be just as dangerous as fear, since it can prevent you from taking profits when you should and can lead to your once-profitable investment becoming unprofitable since, generally speaking, prices fall faster than they rise.
In order to be successful in the investment world you need to overcome emotion and trade systematically. Allow me to repeat that: In order to be successful in the investment world you need to overcome emotion and trade systematically. Trading systematically will allow you to always have a worst case scenario in mind. This eliminates the fear of the unknown and can assist you in justifying your decisions whether you're working with $1,000 or $1,000,000,000. Of course there are many ways to overcome fear and greed when investing or trading, but there are a few that, in my opinion, will help you to rapidly develop the core personality traits of a successful risk manager and thus, hopefully a successful investor or trader.
Give yourself a comfortable risk tolerance:
- First and foremost, you need to know what your risk tolerance is. I'm not talking about the "how attached to my money am I/how big are my balls?" type of risk tolerance. There is no way you can quantify that so it's really pretty useless. What you need are hard numbers. Here's an example: Regardless of your portfolio size, you need to accept that on every losing trade you will lose some percentage of that value. If your portfolio value is $10,000, pick a number that you might be comfortable with, say 1.5%. This tells you in cold, hard numbers that on any losing trade you could lose up to $150. Are you ok with that? If not, reduce your percentage until you are.
- Of course if you're trading mid or long-term (investing), you will need to allow yourself a bit more leeway (with a $1,000 beginning portfolio invested in two stocks maybe you are willing to lose up to 12% of your investment before you cut your losses, for example), since the stock will swing much more given a larger timeframe. An added benefit this provides for you is to give you a "bust allowance" or a number of allowable bad trades before your portfolio is totally busted. As an example, with a $10,000 portfolio and a 1.5% risk tolerance, your bust allowance is 66.67 meaning you could potentially make around 66 terrible, losing trades before your portfolio was completely diminished (not considering commissions of course). This helps when you make a really terrible trade and lose a ton of money very quickly, since you know in the grand scheme of your investing that you could still do the same thing 65 more times before you were totally busted.
- Whatever your tolerance, the point is that you need to quantify it. Make an Excel spreadsheet detailing your portfolio value, risk tolerance, and bust allowance. Experiment with different values and see how you feel when you actually look at the dollar amount. It's easy to assume that 1.5% is not a lot of money, but when you're throwing $15,000-$20,000 at a trade 1.5% suddenly becomes more than many people make in a full eight-hour workday. It's especially important for high frequency and daytraders to use this strategy since you will be trading multiple times in a day and prices can both skyrocket and plummet in a matter of seconds (no, I'm not exaggerating).
- A trade journal allows you to track your progress throughout your investing and trading adventures. When you buy or sell a stock, document everything. Write down the price you bought, where you set your stop loss (see stop losses below), the reason you decided to buy at that price, the price you sold, how much money you made, the reason you sold when you did, any potential pitfalls, what your risk was as well as your potential reward (see reward to risk ratios below) and anything you could have done better or any thoughts you had about the trade (things you were worried about, etc). Doing this for every trade will allow you to see in black and white what you need to improve upon and what you're good at, as well as what works and what doesn't. It is especially important that you document your failed trades/investments and the reasons that they failed. Understanding why you lost money is the key to making money the next time!
- A stop loss is a special kind of order that must become your best friend! When you enter a stop loss order (commonly known as a "stop") your stock will automatically be sold if the price reaches a certain level. Stops are extremely important for daytraders and high-frequency traders because prices can change so rapidly during the day that it is literally possible to lose thousands of dollars in the amount of time it takes you to go to the bathroom. By setting a stop loss, you eliminate this risk and gain peace of mind, knowing that if your stock suddenly takes a dive you will not be turned into a homeless person.
- As an example, let's say you buy 100 shares of a stock at $10. Your total investment is $1,000 (plus commissions). If you enter a stop loss order for your 100 shares at $9.50 (a 5% loss), the order will stay active until the price reaches $9.50. At that time, an order to sell at whatever the current market price is (which should be close to $9.50) will be entered automatically, and your stock should sell almost instantly. By entering the stop loss, you have successfully capped your risk at $50 (5% of $1,000), even if you're not near your computer or paying any attention to the market when the price drops.
- Managing your risk with stop losses is one of the most important parts of investing, even if you are not trading on a daily, weekly or even monthly basis. If you are an investor, you might only check your stock twice a month, so you really need to consider what will happen in the time you're not watching. Prices can and do fluctuate wildly and using stops will prevent you from losing more money than you can tolerate.
- One other thing: stick to your stops. If you cancel your stop because you are hoping the price will turn around, you are wrong. Cut your losses and move on. I know it sucks. We all hate losing money but trust me, you will hate yourself a lot more if you cancel your stop and then lose another 5% before finally selling out of frustration. Over time, you will find that it is much more profitable to just stick to your stops, cut your losses, learn and go make a good trade to make up for it.
- A position is an investment. If you have $1,000 worth of a stock, you have a $1,000 position. With this in mind, another vital part of managing your risk effectively (and thus making money!) is to make sure your positions aren't too big. If you have a $10,000 portfolio and your risk tolerance is only 1.5%, you can only afford to lose $150 before you are outside of your risk tolerance. Now imagine that you've invested $7,500 into a single stock. You can only afford to lose 2% on the value of that stock from your buy price before you'll have to sell in order to stay within your risk tolerance. Now imagine that the stock only costs $1. On this particular stock, literally, losing two pennies ($0.02, two cents!) will cost you $150. Conversely gaining two pennies will earn you $150, but personally that is not the kind of risk I want to take.
- When making any investment, long-, mid- or short-term, you really want to be able to safely absorb about a 5% loss before you go outside your risk tolerance. This doesn't mean that you should always use a 5% stop loss, but as a worst case scenario, you should be able to if something goes wrong. 5% is also not some magic number, it's just something that I've found works well, and I think it works well because prices do fluctuate throughout the day and there are people out there who will manipulate the price just to trigger stop loss orders and pick up cheap shares. If you only have a two cent risk tolerance, you're very likely to get "stopped out" (have your stop loss order executed and the stock sold automatically).
- To combat this issue, it's best to size your positions accordingly. Consider your total risk tolerance (in our extended example, $150). Now divide that number by the 5% you need to be willing to lose off the buy price of your stock (this will give you a maximum position size, in dollars: $3,000 for us). Once you have a max position size, you can simply divide by the price of one share to determine how many shares you can buy. Again, it is simple to create this type of calculation with a spreadsheet so you just have to pop in a couple numbers and you're ready to buy. You can even take it a step further and calculate the price you would need to set your stop loss at (95% of the current share price) and then look at the chart to determine if there is any significance to that number (e.g. is it right under support, does it look like the stock could hit it fairly easily, etc). Keep in mind that you don't always have to buy your max position size. Sometimes I only buy a quarter or a half of my max because I want to be able to allow the price to fluctuate more than 5% down while maintaining the same level of risk.
- A reward to risk ratio can tell you systematically how likely it is that your trade will succeed. Consider this: if you buy a stock at $6.25 and you've determined that there is support for the price at $6.00 and resistance against the price at $6.50, your potential reward is 25 cents while your risk is also 25 cents. This is a 1:1 ratio and is statistically nothing more than a coin flip. I don't know about you, but I don't want to be betting thousands of dollars on a coin flip. Instead, you must find investments and trades that provide you with a solid reward to risk ratio. The higher you can get this number, the better. Personally, I prefer to buy with a minimum 2:1 reward to risk ratio (i.e. risk 5 cents to make 10), but ideally I want to shoot way, way higher.
- Another way to look at this is potential gain to potential loss. Ideally you want to have the potential to make at least twice as much as you could lose. If you are risking $150, you want to be able to make a minimum of $300 in order to make it worth it. Risking $150 to make $150 or less is not only stupid...over the long term it is financial suicide. Thus far, almost all of my very profitable trades have had r/r ratios above 5:1, and about 90% of my unprofitable trades have had r/r ratios below 2:1. To calculate the reward to risk ratio, simply divide the amount you could gain by the amount you could lose. Assume the same example as above, but this time there is support for the stock at $6.20. You buy at $6.25 and set your stop loss at $6.19, just under support. Now your reward to risk ratio is .25/.06 = 4.167 or about 4:1.This is a low risk trade that is likely to be profitable for you.
- This step is often the hardest. It's easy to sit back, throw your hands behind your head and watch your account value rise. What's not easy to do is find the top (or the bottom) of a price movement. It is impossible to know where the price will turn around and if you try to do it, you will ultimately end up losing money. Remember, you can always buy more if you sell too soon!
- One technique that I personally love for managing profit-taking is called scaling. Under this strategy, once I know that a stock is comfortably on its way up, I will sell off about half of my position (usually at around a 5% gain) and raise my stop loss (cancel the original one and enter a new one) to the price I originally bought at. By doing this, I lock in a 5% profit and make the rest of the trade free. If a stock breaks through multiple resistance levels in a single run, I might even set my stop under the first resistance level (which is now support, remember?) above my buy price. This guarantees that even if I am wrong on the run and it immediately turns over and plummets, my stop will kick in above the price I bought at and I will still make money. Of course you will rack up more commissions this way, but remember that this guarantees that you will make a profit on the trade itself (as long as your position is sized correctly and you are properly managing your risk!) There is no question that once you sell half of your position and move the stop to the price you bought at that you have made a profit, and there's nothing anyone can do to make you lose money on that particular trade. Worst case scenario: the price falls back to your buy price and you stop flat with no gain, but no loss. I should mention that you do need to consider commissions here, but I can also tell you that if you are worried about your trade turning into a loss at the hand of a $7 commission, your position is not sized correctly or the trade is too risky and you need to re-evaluate.
- Scaling is probably one of the most valuable and important things I've ever learned when it comes to buying and selling stocks, because it allows you to guarantee yourself a profit and at the same time allows you to completely forget about the trade and move on to making other successful trades if you want to (after all you've already made some money on it and the stock will automatically sell at or above your buy price if you stop watching it).
If you'd like to see and use a trade journal/risk calculator click here (File > Download as > Excel if you want to save it and learn how it works).
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