Managing Your Risk

Well Traders, probably the most valuable lesson I learned last year and at my recent INVESTools classes is the absolute importance of Managing your Risk. Because trading can be very emotional (and the death knell of ANY trader), it is paramount that you reduce trading down to your fundamental/technical analysis/strategy, and then simple mathematical equations. By doing this, and sticking to your goals, both profitable and not, you are managing your emotions, which help to manage your risk.

Dr. Alexander Elder, who wrote "Come into My Trading Room," a book I highly recommend, establishes his own risk. He will not risk more than two percent (2%) on any one trade, and no more than six percent (6%) at any one time. While I subscribe to his 6% overall risk, I only risk 1% in any one trade. This gives me a minimum of 6 trades I can be in at any one time.

I created a Risk Management Tool on Microsoft EXCEL which enables me to monitor all my postions in different accounts to see where I am with my "at-risk" trades (those exposed to the 1% loss). This helps me manage my risk and exposure. The sheet, shown below, begins with total cash available at the beginning of the month, then that establishes my 1% risk exposure, which is $500 based on this example. I also have four different risk calculators based on what type of trade I am playing. Longer term TREND plays have a greater risk because I allow 3% below support of the stock. Shorter term SWING trades I play tighter with only a 1% risk below support. This enables me to correctly size my position for each trade. Since I only trade in round lots of 100 shares, I always round DOWN. This is more conservative, but managing risk should be conservative in order to be successful. Here is a glimpse of my worksheet:

(Click to enlarge, use your browser's "Back" key to return to the Blog)

You can see that I have six (6) fictional trades (I used real stocks, but made up the prices, they are NOT suggestions to buy or sell). However, due to position sizing, I only have 3.4% at risk at this time, or $2,197.00. You'll notice that just under the dollar amount I have the words "Keep Trading" highlighted in yellow. That is because I have not yet reached my 6% "at-risk" limit. Therefore, I am allowed to continue to trade in this account. It also shows I have only $2,390 left in Cash available to trade.

On the right sie of the sheet are the risk calculators. I have them set up for each account because different accounts may have different cash balances. Each risk management is unique to each account. This is how you try to stay ahead of the game.

Here is another worksheet example:

You'll notice I put a few more trades in there. Now, since my "at-risk" exposure has exceeded 6%, the yellow box below the dollar amount at-risk now reads "Stop Trading." This helps alert you to when your exposure exceeds 6% at any one time. Now here is here is where the fun part begins.

Since I now have a little over 6% at risk, I am NOT allowed to trade any more until one of two things happens. The first, if all these positions get stopped out (which would really suck, but could happen), then I must close them ALL, and wait on the sidelines until that month is over. That prevents "Get Even-itis" which is a gambler/trader sickness. You HATE losing (I do too), so you want to "get even" with the market. That leads to irrational trading behavior and could be devastating to one's portfolio. If you get stopped out of all your positions, then you need a break, like stepping away from the Blackjack table when the dealer is kicking your ass. It is a time to regroup and re-evaluate what you are doing right and wrong. It is an important cool-down period.

The other thing that could happen is better. If any of your positions move to such a point that you can move your Stop-Loss position to a point the trade is profitable, then that trade will move off the "at-risk" position (but not off your worksheet, just change the "Stop-Loss" price to your profitable point), freeing up any more available capital to trade.

This chart needs to be re-started at the beginning of each month. Why? Well, your capital position will more than likely have changed from the preivious month, for better or worse. If you started at $50,000 in January and now begin with $53,000, your "at-risk" capital will rise from $500 to $530. Conversely, if the account dropped from $50,000 to $47,500, your 1% "at-risk" amount would only be $475. This helps you with all your position sizing for the month. Remember, we are not trying to get rich quick here, we are trying to beat the Market, and to do so, you need to be steadfast and prudent when trading. It is okay to be wrong. You'll be wrong more often than you are right. However, by trimming your losses to bare minimums, your winners should overcome your small losers making you profitable in the long run, and that's what we are in for, the long run.

The Risk Management Tool is available to purchase for only five dollars ($5). Believe me, this is money well spent if you are trying to manage your trading accounts. Email me at GSOTrojan@aol.com and I'll give you details on how to purchase the tool.

Happy Trading!