Managing risk is perhaps the hardest thing to do when trading stocks. What happens is your ego gets in the way. You’ve done substantial research and truly believe that you have a winning stock or group of stocks. Chances are you do. The problem is that along the way you will encounter some unexpected bumps in the road. The way you handle these side issues can determine a trade being a winner or loser.
Let’s look at a few of these issues. The first is when to buy. On the one hand you want a stock that has momentum and can move higher. But in doing so you don’t want to chase a charging bull. You may enter near the top of a move and get caught in a nasty correction. Always remember that the smart money got into the market just as the market started its move. As it moves higher these traders start to take profits. If enough of them do so you end up with more selling than buying. You end up in the midst of a correction. Your stock may eventually move back up again but in the meantime chances are you got stopped out and lost money. You need extreme patience to wait for the best time to buy. With the Dow Jones Industrial Average having more than doubled in the past three years, it is becoming more and more difficult to find the right entry points.
Let’s say you waited and made your buy at a good point. You can never be sure that you’ve gotten the best price but you feel it’s near a good support level. Fine. Now you’ve got to protect your capital. You do this by placing a stop-loss order. This is an order to sell below the market. If your stock drops to that point you will automatically be sold out. Just as it was important to pick the right entry point, it’s necessary to pick how much you want to risk. You’ve probably heard of the 20% rule-never risk more than 20% on a trade. Forget about it. Don’t even think of risking 20%. Three trades each losing 20% and you’ve lost more than 50% of your capital. Your psyche will get all twisted out of shape and that gremlin “fear” takes hold. You find yourself scrambling to do “catch up.” To stay in the game and play again tomorrow, never risk more than 3-4% of your capital. This means that you are riding with a very tight stop-loss. That’s OK. You can afford to have losing trades. Don’t expect to win at every trade. Even your greatest traders sometimes have more losses than wins. The key is to have bigger dollar winners than losers.
The third step is when to sell. Here again no one knows where the best price is going to be. In doing your research you should have estimated how high your stock will go. When it gets to your target price sell it. Don’t worry or kick yourself when it keeps going higher. Don’t look back and don’t keep checking the price. Move forward. Go on to your next trade.
Keep a record of each trade and analyze what you did right and what went wrong. Remember your mistakes and vow not to repeat them. If you had a bad streak take time off. You will need time for your battle scars to heal. Remember that success is part mind and part gut. You must “feel” like a winner, not just think about it.