The Best 50 Trading Tips: Lesson 4
Section Six – Risk management rules
Tip 1 – Always use a stop loss
A stop loss is exactly as the name suggests, an instruction to a broker to sell a particular stock if the price falls to a certain level, hence “stopping the loss”. If you can successfully do this your capital will remain largely intact ready for the next trade.
A “stop loss” order is an instruction given to your broker (or placed on your trading platform) that is an instruction to “sell XYZ at market when the price trades at you nominated level”.
For instance you own a stock and decide that if the price starts to decline and trades at say $1.65 then you will exit the trade. You then place a “stop loss” at $1.65.
Generally the trade will be executed at $1.65 however there are exceptions. On occasions there may not be enough buyers at $1.65 to absorb your sell order so your order may be executed at a lower price.
There is also the potential for a large fall at the opening price due to negative overnight news. In this case prices may “gap down” and your order may be executed at a level far below your stop loss price.
There is evidence to suggest that traders who use stop loss orders will outperform those that do not use stops.
Tip 2 – Never lower a stop loss
This appears to be a simple rule and easy to obey, however once you start trading and the price of a stock approaches your stop loss the temptation is to lower your stop a few cents. If you have done your homework correctly in the first instance there is no point lowering the stop, that action will only cost you more money.
Every big loss starts as a small loss.
Tip 3 – Consider a time based stop loss
At varying stages during your trading career you will find that you have invested in a stock and the price stagnates, sometimes for several months. Rather than sit around with your capital tied up, wondering what you do, you might have a rule that states:
“If my stock is not in profit after period of one month, I will sell that stock”.
If you were to sell your worst performing stock each month and spend time replacing that stock hopefully with a better performing stock, then you would be constantly improving your portfolio.
Section Seven – Money management rules
Tip 1 – Consider position sizing
Position sizing can be a complex issue. This document is not designed to give you all the possible rules involving position sizing, so do some homework. It is worth your time studying the potential benefits of position sizing. Position sizing is a method of adjusting your position size to suit the risk that you need to take.
For instance let us assume that you have a $100,000 account and are only prepared to risk one percent of that portfolio on any one trade, I.E. $1,000. If you are going to buy a stock at say $1.50 with a .15 cent stop loss then your position size becomes 1000 / .15 = 6,666 shares. (No allowance for brokerage in this instance)
Purchase 6,666 at $1.50 = cost of $9,999
If stopped out at $1.35 = a loss of 6,666 x .15 cents = $999 or 1% of your $100,000 account.
Position sizing can assist in controlling your risk and gives “structure” to your trading plan.
Tip 2 – Never put all your eggs in one basket.
See “Tip 11” (Section 1 – before you trade)