Secret #5 - How To Control Risk
Of "The Five Secrets You Must Know To Make Money In Stocks," Risk Control is
definitely the most important. Although most people ignore the dangers of market
risk, neglect in this vital area is the main reason that more than 80% of all
individuals lose money in stocks.
-- Planned Losses vs. Unplanned Losses
There are two types of losses - planned and unplanned. An unplanned loss is the familiar, common type that all new traders experience. It happens when a trade unexpectedly moves against them, and they have made no previous plan to deal with it. The loss continues to grow until it becomes an ugly problem.
A planned loss is entirely different. A planned loss gets you out of a loser early enough to prevent any serious damage. Instead of making you feel nauseated, a planned loss leaves you calm and confident. Why? Because you made an intelligent decision and took the appropriate action.
It's always smart to take a planned loss that won't seriously injure your
trading account. It's never acceptable to let a small loss grow into a large
-- The Basics Of Risk Control
There are two factors that should always be included in a complete Risk Control plan.
1) An Exit Strategy that minimizes losses. We've covered this in section #3 - "How To Enter & Exit at the Right Time."
2) A Money Management method that utilizes Position Sizing tactics.
A well-planned Exit Strategy minimizes losses for any one trade. Position Sizing keeps a series of losing trades from causing you serious financial harm.
-- Position Sizing – The Key To Risk Control
One of the most effective ways to control risk is through Position Sizing. Some
people refer to this as "Money Management." No matter what you call it, this
vital technique is used to decide how much of your trading capital to put into
Although some folks are foolish enough to think they can permanently avoid losing streaks, consecutive losses are a natural consequence of the laws of probabilities. Even the best traders experience them.
-- The Odds of Streaks
The simple act of flipping a coin goes a long way towards explaining "streaks." While the odds of each flip turning up a heads or tails is fifty-fifty, a series of 100 flips will produce several winning and losing streaks of surprising length.
Try it and you'll likely find periods of ten or more consecutive winners or
losers. After your first 100 coin tosses, try another hundred. The more flips,
the more likely you are to see longer streaks.
1) Traders and investors tend to abandon otherwise successful strategies because they experience a losing streak and don't understand why it's happening.
2) Risking too much on each trade allows an occasional - yet normal - losing streak to seriously damage a trader's capital.
-- The Myth and The Math
The common market myth accepted by most individuals ignores the math. In fact,
there's hidden danger in the math of losses that usually isn't revealed until
it's too late.
-- A Simple Yet Powerful Way To Size Your Positions
Although there are a large number of complex methods you can use for Position Sizing, a simple - yet very powerful - strategy is to risk a small percentage - say one or two percent - of your total trading account on each trade.
Note that the amount you are risking is not the same as the amount of the stock purchase. If the total value of your trading account is $25,000 and you risk 2% of that, your risk for each trade is $500.
Let's say you buy 137 shares of a $45 stock. Your initial position value for
that trade would be $6185. However, if the price drops by $3.50 per share,
your $500 of risk is gone. At that point you would immediately exit the
-- The Bottom Line of Risk Control
Similar to flipping coins, strings of losers often occur in trading - even when the odds are in your favor. When used as part of an overall Risk Control Strategy, Position Sizing keeps this mathematical fact from crushing your capital.
Knowing how to control risk allows us to continue trading confidently – despite running into a series of losers that would knock most traders off their feet.
Risk Control not only protects traders from financial damage, it prevents the associated emotional damage as well. Most people choose to ignore market risk. Though some are "lucky" for a while, eventually the odds catch up with them.
All traders and investors should have a sensible and clearly defined Risk Control Strategy working on their behalf.