Trading is easy; you buy and sell. Managing trade risk is difficult.
But proper risk management is what separates successful traders and investors from the rest of the pack. And managing stock risk requires keeping your ego in check and accepting the fact that you’ll be wrong sometimes.
What is trade risk?
Trade risk is acknowledging your chosen investments might not perform how you expect, potentially resulting in lowered investment gains or loss of your original investment.
Here are some tips on how to manage trade risk.
New traders tend to get this wrong. If your positions are too large, you risk wiping out a bulk of your capital, inhibiting your ability to trade more trades. A good rule of thumb is to never risk more than one percent of your capital in any one position. For example, if you have a $10,000 account, don’t risk more than $100 on any position.
Here’s an example of how to properly size your positions.
Let’s assume you saw that Inovio Pharmaceuticals Inc. (INO) announced that its HIV vaccine, PENNVAX-GP, produced some of the highest overall levels of immune response rates ever demonstrated in a human study by an HIV vaccine. This news was reported ahead of the bell, and you consider it a bullish catalyst and looked to get long the stock at the open.
Take a look at INO on the daily chart.
Let’s follow that rule of thumb — not risking more than one percent of your capital on any one position — and assume you were able to purchase shares at the opening, $9.65. You might be wondering how many shares you would be able to purchase, assuming you have a $10K account.
The key here isn’t the stock’s price, but the amount you are putting at-risk. The stock could fill the gap to its previous day’s closing price of $7.13, meaning you are risking just over $2.50 per share; at this point, your maximum position size should be slightly less than 50 shares, and you would set a hard stop just below the $7.10, if and when it gets there.
This brings us to our next key to managing trade risk, setting stop-losses.
Trade ideas don’t always pan out as expected, and stop-loss orders help to remove some emotion from trades that aren’t working out.
A stop-loss order simply sets the price at which you would sell your shares and take a loss on a trade. While your trader’s mentality when you’re down might be that the stock could reverse and work in your favor, you should always look to limit your losses. Let’s look at how you could set a stop-loss order, using key technical levels as an indication of where to hit out.
Here’s the daily chart on the First Trust Large Cap Value AlphaDEX Fund (FTA).
Notice that the ETF has clearly defined support and resistance areas. That in mind, you could use $48.00 or slightly below that point as your stop-loss. If FTA breaks below the key support area, it might be an indication that the stock could fall lower; you stop out and suffer a loss, but it’s not as big as it might be if you stick around hoping for a reversal.
Setting profit targets and knowing when to cut losses is a third key to managing risk. Successful traders want securities in which the potential reward is larger than the potential risk taken. Risk-reward ratio is one tool that can filter out which stocks you might trade.
Here’s an example, in the daily chart of General Mills Inc. (GIS).
Let’s assume you’re considering to get long GIS at $56.75, on a break of the upper trendline in the falling wedge (which is generally considered a bullish pattern). Additionally, let’s assume you would set your stop-loss at $55.75, just above the area where the stock made a double bottom. That said, your first level where you would look to take profits may be at the next level of resistance, roughly $58.25. With a buck’s worth of potential loss and $1.50 of possible gain, the risk-reward ratio is 1-to-1.50. This isn’t particularly favorable; new traders generally should seek a ratio of 1-to-3 or higher to protect their precious capital early in the game.
It takes practice to implement these three keys to managing trade risk in real-world trading. These aren’t the only risk-management tools you’ll want to use — there are a plethora of other methods out there — but they are the ones that should be particularly helpful as you launch your trading career.
Kyle Dennis runs Kyle Dennis’ Biotech Breakouts (biotechbreakouts.com). He is an event-based trader, who prefers low-priced and small-cap biotech stocks.