When I began learning to trade stocks I quickly realized that proper risk management would be critical to my success. In my first year trading stocks and options I discovered a very common pattern. My losses were bigger than my winners. Despite the fact that I was winning more than I was losing, I still lost money overall. The reason was because I had a negative profit loss ratio.
I discovered that it is far more important to manage risk properly than to pick the right stocks. My friend Ross over at Warrior Trading (www.warriortrading.com) is also a big advocate of focusing on risk management first and on stock selection second. Even though my first years of trading were a struggle they led to the creation of risk management principles that I still use today.
What Is Risk?
Risk in the market comes in various forms and the type of risk you experience will vary depending on your trading strategies. The areas of risk I typically discuss are:
- Exposure Risk
- Time in the Trade
- Distance From Your Stop
- Slippage Risk
- Float and Volatility
Exposure risk is a big concern for swing traders and long term investors. Your exposure risk is the amount of money you have tied up in the position. For example, if you want to buy 1000 shares of a $120 stock like Apple ($AAPL) it will tie up $120,000 cash. If you are simply day trading the stock it usually isn’t too much of a concern if more than 1/10th of the portfolio is invested. Most active investors use the rule of 1/10ths.
The rule states that you should never have more than 1/10th of your portfolio in a single position. Day traders typically use much larger percentages of his or her portfolio in single positions in order to profit from smaller intraday moves. This increases risk while the position is open but risk is also offset by the shorter period time exposure.
Time In The Trade
Day traders may face higher levels of risk due to exposure, float and volatility, and slippage, but those are often offset by very short trade times. Time exposure is very limited for most day traders. The simple equation is that the more capital exposure you have over a longer period of time, the more you are risking in a trade.
While a stock may trade sideways for weeks there is always the potential for overnight news to come out and cause extreme volatility. In order to mitigate the risk of time exposure traders can utilize an options strategy of buying calls or puts. My friend Jeff has written extensively about using options to reduce risk.
Distance From Your Stop
When I’m day trading I am primarily concerned with the distance between my entry price and my stop. Most day trades that end in losses are simply because my stop was hit. The stop is the pre-determined price where I’ll bail out if things aren’t looking good.
If I can keep the distance between my entry and stop tight then my losses will be smaller. As a beginner trader it’s easy to chase strong moves and forget about the safety net that is your stop. It took me a long time to learn to always write down my stop before I entered a trade.
A commonly overlooked element of risk in the market is your slippage risk. Slippage is the difference in price between when you hit the sell button and your sell order is accepted at the market and filled. Market prices in volatile markets can move so quickly that the difference between profits or losses can be seconds. Most active traders will use Limit Orders and rely on high speed direct access market routing system.
These orders will set a limit to the price you are willing to buy or sell at. In contrast, a Market order will fill at market prices, even if they are much different from the price you were expecting. Stocks that are particularly susceptible to slippage are low float stocks or stocks experiencing higher than average volatility.
Float And Volatility
The float of a stock is a critical piece of information. The float tells you how many shares are available on the open market to be traded. This represents the supply. Most large S&P 500 Companies have large floats of over 500 million shares. Some even have a float of several billion shares. When a stock has a large float it takes a tremendous amount of buying or selling volume to create a big move. In contrast, many of the small cap stocks have floats of less than 50 million shares.
A small float stock can be extremely volatile because if there is a breaking news catalyst the prices can move extremely quickly. As a day trader we look for small floats because the increased volatility creates larger opportunities for profit. The struggle for any trader is finding a good combination of volatility where risk can still be managed. Some stocks have floats as small as 1 million shares. These stocks can experience what’s called float rotation. That is when the entire float of the stock changes hands in one trading day.
Profit Loss Ratios
The ultimate ticket for success in the markets is understanding all your elements of risk and positioning each trade so that you have a positive profit loss ratio. Your profit loss ratio is simply your average winners vs your average losses. This is usually defined by dollars or cents of profit per share. For instance, a 10 cent average win vs a 20 cent average loss would be a negative ratio of 1:2. A 20 cent average win vs a 10 cent average loss is a 2:1 positive profit loss ratio.
Trades must always strive to have positive profit loss ratios. To illustrate the importance of the profit loss ratio, lets look at some statistics.
- 2:1 Positive Profit Loss Ratio = You are breakeven with 33% accuracy
- 1:1 Flat Profit Loss Ratio = You are breakeven with 50% accuracy
- 1:2 Negative Profit Loss Ratio = You are breakeven with 66% accuracy
If you can make even small strides to improve your profit loss ratio you should see significant impacts in your trading results. A great deal of trading is based on understanding the statistics of a successful trader. Matching those statistics is not just a matter of choosing the right stocks but instead managing risk on every trade.
Become A Master Risk Manager
The first step to risk management is recognizing the areas of risk you face every day in the markets. Understanding risk and developing techniques for offsetting your risk is critical for long term success in the markets. Even though I’m a trader I often think of myself as a risk manager. I spend hours everyday analyzing the risk levels for the various trades I’m considering.
If a trade doesn’t have the potential to give me a 3:1 profit loss ratio in less than 1 week I won’t take the swing trade. If a day trade doesn’t have the potential to give me a 2:1 profit loss ratio in less than 30 minutes I won’t take the trade. Having these simple rules in place is what keeps me profitable month after month.
Author Bio – This post was written by Joshua Rodriguez, owner and founder of CNA Finance.