How to control risk? How much time does an average beginner spend calculating and managing risk? Most likely zero, zip. All beginners, no matter how bright, make mistakes, and take losses. Be sure to keep your losses small, don’t let them threaten your survival.
The rules for managing the risk that we’ll show you may feel annoying for beginners with tiny accounts, because of proper risk control limits trade size.
The most important rule of risk control is the 2% rule: never risk more than 2% of your account equity on any given trade.
How to control risk? Begin by writing down three numbers for every trade: your entry, target and stop. Without them, a trade turns into a gamble.
Simply understand that every trade requires a stop. That distance from your entry to that stop determines how many dollars you’ll risk per share.
Let’s say you plan to buy a stock at $20 and expect it to rally to $25. Hence, that is your target. As you are not a gambler, you decide to place a protective stop at $18. That is the level you set through technical analysis, we will explain that later. Buying at $20 and protecting at $18 means you’ll be risking $2 per share in this trade.
How, much money do you have in your trading account? Let’s say you have $10,000.
What is 2% of $10,000? It is $200. This amount represents the maximum amount you’re allowed to risk.
How many shares of that stock may you buy? Well, if your maximum permitted risk is $200 and your risk per share is $2, you may buy up to 100 shares. You may buy fewer shares but you may not go above the number given to you by the 2% rule.
The maximum number of shares you may buy is determined by your risk per share and your total permitted risk.
This is the triangle of risk control.
It isn’t mandatory to risk 2% of your account on every trade. You can risk less, or may never risk. That depends on how big is your account. The bigger your account, the lower the percentage you want to risk.
But there is another rule.
The 6% rule states that you must stop trading for the rest of the month whenever your losses reach 6% of your account equity at the beginning of that month.
If and when losses start piling up, take that as a sign that your method isn’t working in the current market environment. It’s time to step aside for a while.
Once your drawdown hits 6%, that’s the end of trading for the current month. There are no new trades. The 6% rule breaks losing streaks, giving you time to think and regroup.
Most traders have been ruined either a single disastrous loss or a series of losses. None of them fatal, but together they short an account.
You may never boost the limits, but you can lower them, especially the 2% maximum
loss per trade.
If you use the 2% and 6% rules, a series of only three losing trades can knock you out of the game early in the month. If you reduce your maximum risk per trade to 1%, you’ll double the number of trades you may take before being forced to step aside. Lowering your risk per trade to 1% or less will give you more latitude to practice your tactics.
But you have to understand something. It is very hard to diversify the tiny account. With a large account, you have a different situation, it tends to take beginners into a fake sense of security.
From our experience, the sweet spot for beginners is somewhere in the $20,000 to $50,000 range. It is big enough to diversify but small enough not to get carried away.
Focus on learning and gaining skills. Trade small and keep good records. If you do it right from the start, you’ll be making good money later. Never overtrading, never get hurt near the starting line, and never become depressed.
Risk management will make you a safer trader. The good recordkeeping, a key tool for your growth as a trader.
So, we have to jump there.
Many traders keep losing money, repeating the same mistakes.
The good trader always remembers what he did right and made money or what he did wrong and lost. In few words, he stopped repeating the wrong moves.
To be honest, no one has the capacity to remember all the fundamental details of trading tools, systems, entries, exits, news reports. That’s why you need to write them down. The point is that successful traders keep good records, review them, and learn from them.
You need to keep both records: a spreadsheet and marked-up charts of your trades.
Let’s see the spreadsheet first.
You can see two lines from the spreadsheet, reflecting a trade made. You can see the usual numbers, such as entry and exit dates and prices, gross and net profit or loss. But this spreadsheet includes columns for rating the quality of each trade as well as of every entry and exit. You can call them buy, sell and trade grades. You have to grade your performance in order to improve it.
The vital trade grade reflects the percentage of the price channel that the trade earned or lost.
This formula compares your profit or loss in a trade to the spread between channel lines on the day you entered that trade. So, the trade grade reflects the percentage of the maximum you were able to catch. A grade above 30% makes an A-quality trade. Don’t oscillate, set reasonable goals. Anything above 30% is excellent.
Buy and Sell grades refer to the quality of every purchase or sale. Each of these categories is based on a single bar showing how your entry or exit relates to the high and the low points of the day.
You want to buy far away from the high and near the low of the daily bar as possible. If you buy in the lower half of the daily bar, your rating for that buy is over 50%.
That is wonderful.
If you buy in the upper half of the bar and sell in the lower half, you’re feeding the sharks. Of course, no one can definitely tell what will be the high and the low of the day. But having consistently low ratings is a sign that you need to be more disciplined.
The spreadsheet above shows two lines documenting one trade. Because the trader purchased that stock in a single trade but sold it in two part payments. This is marked by the entry commissions on both lines being boxed together.
And you can see, the buy grade was 74%, the meaning trader bought near the bottom quarter of that day. Notice also that the closing price for that day is colored green because his purchase price of $92.85 was below the closing price of $93.17.
This meant that the trade was profitable at the closing time.
Besides of numerical records and ratings of all your trades, it’s very good to keep a visual diary of your trades. Save a picture of your stock and its indicators on the day you buy it. And take another picture on the day you sell. When reviewing them later you’ll see what works well and what doesn’t work in your approach to trading. Those photos will help you in the future.
Keeping a visual diary of your trades along with numerical records will raise you above others. You will have what they don’t have: risk management and record-keeping. These tasks are not as exciting as looking for trades and entering them.
But they make all the difference between long-term winning and losing.
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The rule of risk control is the 2% rule which means:
How many shares of stock you can buy for $10,000 if your maximum your risk per share is $2?
What determines the maximum number of shares you may buy?