5 Simple Rules for Risk Management

Successful traders are adept risk managers. Full stop. You can be a lazy scanner and a mediocre technical analyst and still make money day trading. But if you are an undisciplined risk manager, you can’t compensate for it with scanning or technical analysis. Here are five simple rules to guide your risk management.

Proper Entry Points

Identifying a hot stock that’s in play is only the first part of the trading equation – you must also know where to enter it. This is a problem for many day traders in the first half an hour of the day, in particular. They see a momentum stock gap up with a ton of volume. It has some great fundamental catalyst behind it and a solid daily chart, so they jump in. And then they often end up with a huge loss.

Here’s what happened: they didn’t wait for an actual setup, so when the stock started to pull back they didn’t know where to get out. They rode it down far too low, taking a huge loss. Adding to the frustration, it often finds support shortly thereafter they exit and then runs again. You need to see a reliable intraday pattern, so you know where to stop out if it goes against you and where to scale out if it runs. Otherwise, the tendency is to chase, and if you chase, you die.

Scale Out

Speaking of scaling out, this is a crucial tactic that will do wonderful things for your PnL. ‘Scaling out’ simply means that you sell part of your position – usually 1/4 or 1/2 – once you have some profits, then let the rest ride. I look at it as the best of both worlds: you get to lock in profit but also keep the opportunity to hit a homerun. This also relieves so much stress and pressure, as you know that whatever happens, you’ve made some money. But, you can also be a part of a big move if it happens.

I like to set a stop for my remaining shares at my original buy price, so I can just let the remainder ride.

Size Your Positions Appropriately

‘Size your positions appropriately,’ they say. Great. But what does “appropriately” mean? The answer varies from one trader to the next, but the two most common mistakes I see made are position sizes that are too large or too small. A position size that is too large will stress you out. You’ll feel like there’s so much money on the line (as a percentage of your account size) that you’ll make stupid decisions, like getting out of a position too early and not honoring your original stop or scale out prices. It’s like flying a jumbo jet 30 feet above the ground – every tiny movement will give you a heart attack.

But it’s possible to go too far in the other direction and set yourself up for failure with position sizes that are too small. Trading will always involve commissions. You need to go into every trade knowing that you’ll have a minimum of one entry and one exit. If you scale out, as you should, it will be more like three or four. So with a $8 commission, you are starting $16 – $32 down on every trade. If your position size is too small, you’ll need a huge move to overcome that. If it’s going to take a 5% move for you just to break even, you are setting yourself up for failure with a position size that’s too small.

Honor Your Stops

The stock ran like crazy out of the gate! The news was incredible. Everyone seems to be trading it. But it reversed hard and you hit your stop loss, nonetheless. What do you do now? You get out. The stop loss point you picked before you entered the stock was made while your head was clear – there was no money on the line yet. If you decide to ignore that stop once you are in the trade, you’re making a decision when there’s a lot of emotion involved. This rarely ends well.

Now it’s important to note that your initial stop loss could have been poorly placed. But the time to decide that is after the trading day is done; look at your trading journal and see if you are frequently stopping out of trades only to have them turn around and fly higher. If so, you might need to change your stop loss guidelines.

You Will Have Losses

Risk management does not mean you will never lose. In fact, if your goal is to never lose any money you’ll end up committing one of the mistakes above, like making your position sizes too small, or exiting before your stop is hit (not honoring your stops can mean getting out early, too!). Risk management is about keeping your losses small and controlled and your gains larger and controlled. If you do that using the tips above, you’ll be on track to keep that account growing.