HomeTrader's Free Introductory Seminars are held weekly in 5 capital cities around Australia. Come along and learn how the stock market works, how to buy and sell shares and CFDs and how you can trade from home. Everyone is welcome, you don't have to have prior knowledge of the stock market or trading to attend. Register now!
Hello - and welcome to Episode 6 in our ongoing series on Successful Trading. In this episode, we are going to look at Risk Management and then what I refer to as the Arithmetic of Trading. We’ll start with Risk Management. This is simply THE most important part of the business. You may have heard that before; you may have READ it before. There’s a reason for that – it’s true! You can fiddle around endlessly with ALL the other components of your trading plan, but it all amounts to nothing if you don’t get your risk management right.
Now – We KNOW you we’re going to get losing trades. Not only will we get losers, we’ll get groups of them. When we do, as we have mentioned before, the value of our portfolio drops - we call this Drawdown. The primary objective of trading is to manage the impact of such a group of trades – and by so doing, manage the associated Drawdown.
The beauty of a properly constituted Trading Plan is that YOU decide how much Drawdown you are prepared to accept – unlike the average Investor, who is at the whim of the market. There are 2 primary components involved in doing this. Firstly, we can limit the amount we lose in any one trade. Secondly, we limit our exposure to any one stock.
When we first take a trade, we set an initial or fixed stop loss, which acts like a safety net under the trade. If the price falls to this level, we will simply close the trade and move on. In so doing, we are in charge – we decide the outcome! Here’s an example of this in action In this example entry on June 1 at $5.40. The Fixed Stop Loss is then set at $4.52. If the price drops to this level we will get out. The first thing to note is that we haven’t set the exit point too close to the action. You have to give a stock room to breathe. This is called the Stop Size. By setting up like this we are controlling how much we lose – we are managing the risk in the trade.
In this case, the stop loss is set at a size of $0.88 cents. So if, for example, we buy 227 shares – we limit our loss should the trade go against us to just $199.97 (in this example). The key point is that we limit the loss! Now of course, we don’t always get out where we would like – shares do gap occasionally. By the same token, not all trades go completely against us. Some will head up first, before falling back. These will not cost us everything we were prepared to risk - And from our back testing, we can see the average of our losers – and ensure that this average is less than our maximum loss.
But what happens when the share price drops (or gaps) 50% in value overnight? Well, first off, the occurrence of such an event, particularly in a stock bought as a result of following the methodology we teach at HomeTrader is very rare indeed. In fact, we have to look back as far as 1999 – in this instance, it was Biota. It closed at $9.10, opened the next day at $5.00, then dropped immediately to $3.00, before recovering to close at $4.35 This is the definitive example of why we don’t put all our eggs in the one basket.
To contain the damage from an event like this, it’s essential that we don’t have too much exposure in any one place. We do this by limiting our position size. Let’s say you’re a trader with a total capital of $10,000. By having a limit of 20% in any one trade means you have a maximum exposure of $2,000. A worst-case scenario doesn’t mean that it’s all over. We survive, in order to take the next trade.
Let’s turn back now to have a further look at the benefits of containing our losses. I call this the Arithmetic of Trading. Let’s imagine we have that same fund of $10,000. Let’s also assume that we’ll limit our loss in any single trade to 2% of that fund – or $200. For the sake of the exercise, we will assume that our universe of trades is 40% winners, 60% losers. So out of every ten trades, we we’d expect 4 winners & 6 losers. Despite knowing that some of our losers will have gone up first we’re going to assume that all of our losers cost the whole amount. On the other side of the equation, we’ll work on an average win of $600 – an average win to an average loss ratio of 3 to 1. The reason for this is that we let our profits run.
We will look at this in more detail in the next episode, but for the moment, I’m using my benchmark of 3 to 1 in a base-level medium-term system, trading just the long side of the market, without any leverage. This ratio will vary with different trading styles, but it will give you the overall idea. On the right hand side, the 6 losers cost us $1200. On the left, the 4 winners make us $2400. The difference is a profit of $1200.
This exercise raises a number of points.
1)Firstly, it shows the benefits of being able to take a small loss and let profits run, rather than succumbing to fear and jumping out too early.
2) Secondly it shows that we can be profitable with a win rate at just 40%. In other words, it’s not just about picking winners – you don’t have to be right ALL the time!
3) Thirdly it shows that trading, done properly, creates a Positive Expectancy Environment. This is opposed to walking into a casino, where the house and the government take their slice, to leave the punter in a Negative Expectancy Environment – one on which you expect to lose!
So you can see that through the process of controlling our losses and allowing our winners to run, we can dramatically alter the equation of trading in our favour. This is the essence of what it means to be a systematic, rather than impulsive trader. I makes the difference between success and failure.
In the next episode, we’ll look at how to lock in profit. In the meantime, if you’d like further information, I suggest you visit our web site at hometrader.com.au, and book in to one of our free 2-hour Information seminars.
Successful Trading 
