Monday, October 8, 2007

Risk Management

Risk management in my opinion is so absolutely crucial that I'd like to share with you how I determine my risk. Determining your risk before you trade is something a huge amount of traders/investors don't do. Why don't they do it? Because pre defining their risk tells them that they could lose and we all know people don't like losing. Well, if your trading to sustain yourself financially as I am doing now and plan on too in the future then you need to realize that a lot of your trades will be losers.


Now, what we need to do is figure out how much we'll be ok with losing on each of those trades instead of letting them run wild before we feel like puking before we finally sell them for a loss. Screw that noise. If I see a loser I get rid of it ASAP and preserve my capital so I can trade to see another day lol. Without capital my business is done for.


Onward and upward, this is how I determine how much to lose on any one trade.


For example, let's say we have $2,000. It's easier to do in my head with this amount. Ok, the first thing I do is look at how much capital I have and figure out 1% of that. 1% of 2,000 is 20. The reason I use 1% is because it's what I'm personally comfortable losing on any one trade and if I'm on an 3-5 or more trade losing streak losing 1% isn't that big of a deal.


So now we know how much we can lose on any one trade, 20. Now I figure out how much cash I can use. Depending on how volatile the stock is, I'll either pick a 4% stop or a 2% stop, you can use a 6% stop if you really like those crazy volatile stocks. How much cash can I use in order the stock to go against me 4% yet, still maintain a maximum of a $20 loss?


6% stop you can use a maximum of $350

4% stop you can use a maximum of $500

2% stop you can use a maximum of $1,000


Notice that as the percentage amount we risk declines, we use more cash. The more volatile a stock, the less cash we put in. This idea of risk management is one of many out there you can use but I like this one because no matter what stock I get in, I already know how much I'll lose. Once I know that, I'll start looking for stocks that have maximum potential for an upward run. That's when looking for 3:1 risk/reward comes into play now that we know how much we can lose, how much can we gain?

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